cost theory

2. Group Members
 M.Naveed Younas(033)
 Samina Khan(082)
 Usama Rehman(071)
 Ihsan Khalid(066)
Presented To:
Mis.Badr un Nisa
Topic:
Cost Theory}

3. Introduction:
The firm’s costs determine its supply.
Supply along with demand determines
price. To understand the process of price
determination and the forces behind supply,
we must understand the nature of costs. We
study some important concepts of costs, and
traditional and modern theories of cost.

4. Cost concepts:
Costs are very important in business decision-
making. Cost of production provides the floor to
pricing. It helps managers to take correct decisions,
such as what price to quote, whether to place a
particular order for inputs or not whether to abandon
or add a product to the existing product line and so
on.
Costs refer to the money expenses incurred by a
firm in the production process. But in economics,
cost is used in a broader sense. Here, costs include
imputed value of the entrepreneur’s own resources
and services, as well as the salary of the owner-
manager.

5. The Traditional Theory of Costs
The traditional theory of costs analyses the
behaviour of cost curves in the short run
and the long run and arrives at the
conclusion that both the short run and the
long run curves are U-shaped but the long-
run cost curves are flatter than the short-run
cost curves.

6. The Modern Theory of Costs
The modem theory of costs differs from the
traditional theory of costs with regard to the
shapes of the cost curves. In the traditional
theory, the cost curves are U-shaped.

7. Cost Theory
 Definition:
There are many forces behind the process of price
determination for a good. One such force is supply, which is directly
determined by the costs of the company. Theory of Cost explores the
cost concepts, costs in the long and short run and economies of scale.
 Cost Concept :
Cost analysis is all about the study of the behavior
of cost with respect to various production criteria like the scale of
operations, prices of the factors of production, size of output, etc. It is
all about the financial aspects of production. In order to understand the
cost function well, in this article, we will look at various cost concepts.

8. Types of Cost
• Accounting and Economic Cost.
• Outly and Opportunity Cost.
• Direct or Traceable Costs and
Indirect or Non-Traceable Costs.
• Fixed and Variable Costs.

9.  Accounting and Economic Costs:
Accounting costs represent anything your business
has paid for. You can calculate accounting cost by
subtracting your expenses from your revenue.
Example:
Wages to workers employed,Price for Raw Matrial,Rent
,Fule and Power etc.
 Economic costs represent any “what-if” scenarios for your
business. You can calculate economic cost by subtracting
implicit costs from your accounting cost.

10.  Outlay and Oppertunity Costs:
Outlay costs include the actual expenditure of funds on factors
like material, rent, wages, etc. On the other hand, opportunity
costs are the costs of missed opportunities. In other words, it
compares the policy chosen and policy rejected.
Outlay cost concepts are actual expenditures and the books of
accounts record them. Opportunity costs are about sacrificed
opportunities and the books of accounts do not record them.
Direct or Traceable Costs and Indirect
or Non-Traceable Costs:
Direct costs are those that are directly attributable or traceable to
the manufacture of a product or performance of a service, while
an indirect cost cannot be directly attributable or traceable to a
product or service.

11. A simple trick to classifying payments as
direct or indirectcosts
Direct costs encompass the costs involved with creating, developing and releasing
a product.
Direct costs include:
o Manufacturing supplies
o Equipment
o Raw materials
o Labor costs
o Other production costs
Indirect costs encompass costs not directly related to the development of your
business's product or service.
Indirect costs include:
 Utilities
 Office supplies
 Office technology
 Marketing campaigns
 Accounting and payroll services
 Employee benefit and perk programs
 Insurance costs

12. Fixed and Variable Costs:
Fixed costs or Constant costs are not a function of the output. That is,
they do not vary with the output up to a certain extent. They require a
fixed expenditure of funds regardless of the output.
Example:
rent, property taxes, interest on loans, etc. However, note
that fixed costs can vary with the size of the plant and are usually a
function of capacity. Therefore, we can conclude that fixed costs do not
vary with the output volume within a capacity level.
Variable Cost:
Variable costs are cost concepts which are a function of the
output in the production period. Variable costs vary directly with the
outpu.
Example.
Some examples of variable costs are the cost of raw materials,
wages, etc. Sometimes, they vary proportionally with the output too.
However, these variations depend on the utilization of fixed facilities
and resources during the production process.

13. Cost function
Cost function is a function of input prices
and output quantity whose value is the cost
of making that output given those input
prices, often applied through the use of the
cost curve by companies to minimize cost
and maximize production efficiency.

14. Determinants of cost function
Cost feature is the illustration of the
connection among the fee and its
determinants such, as the scale of plant,
stage of output, enter charges,
technology, managerial efficiency, etc.
The fee feature of a corporation can be
expressed as follows:

15. C = (S, O, P, T, E…)
Where,
C = fee (it may be unit fee or overall
fee)
S = represents the plant size
O = stands for the output stage
P = represents the charges of inputs
utilized in production
T = stands for nature of technology
E = represents the managerial efficiency

16. Though there's no preferred constant
with reference to the factors, as they
have a tendency to differ from one
corporation to any other withinside the
identical enterprise or from one
enterprise to any other enterprise.
However, the primary determinants of a
fee feature could include.

17. Plant Size: This is considered as an
important variable in the process of
determination of cost. As the scale of
operations or the plant size, and the unit cost
have an inverse relation. In other words, it
can be said that with an increase in the plant
size the unit cost decreases.

18. OutputLevel:
The output level and the total cost depict
positive relationship with each other. As the
total cost increases with an increase in the
output and with a decrease in the total cost the
output also decreases. This is based on the
fact that increased production is based on an
increase in the use of raw materials, labour,
etc.

19. PriceofInputs:
The cost also gets affected with any change
in the prices of inputs, which is dependent
on the relative usage of the inputs and
relative changes in their prices. That is
because of the fact that with an increase in
the cost of the inputs more money needs to
be paid, with no reduction in the cost from
other sources.

20. ManagerialEfficiency:
A higher managerial efficiency leads to less
cost of production. However, it is very
difficult to measure the managerial
efficiency in quantitative terms. it can be
said on the basis of the above factors that
cost is a part of many factors, which have a
bearing on it and its relation with these
factors

21. COST Output Relationship
It may be noted at the outset that, in cost
accounting, we adopt functional
classification of cost. But in economics we
adopt a different type of classification, viz.,
behavioural classification-cost behaviour is
related to output changes.
The theory of cost deals with the behaviour
of cost in relation to change in output. In
other words, the cost theory deals with the
cost output relationship.

22. Cost Theory In Short Run
The basic principle of the cost behaviour is
that the total cost increases with the increase
in output.
But the specific form of cost function
depends on whether the time framework
chosen for cost analysis is short – run or
long – run.
It is important to know that some costs
remains constant in the short run while all
costs are variable in the long run.

23. Short run
Short run is the period wherein only some of the factors are held
constant and some are variable. Therefore, the costs associated with
both fixed and variable inputs form part of the short period costs.
Short – Run Total Cost:
TC = TFC + TVC
The costs which are found in the short period:
1) Total Fixed Cost
2) Total Variable Cost
3) Total Cost
4) Average Cost :
a) Average Variable Cost b) Average Fixed Cost c) Average Total
Cost
5) Marginal Cost

24. Total Fixed Costs
Fixed cost are costs which do not
change with change in the quantity
of output . For eg .- Salary to
permanent Staff - Licensce fee.

25. Unit Of Output Total Fixed
Cost
0 10
1 10
2 10
3 10
4 10
5 10
6 10

26. cost
unit of output

27. Total variable cost
Variable cost is one which varies as
the level of output varies. If output
falls these cost also falls and if
output increases rises these costs
also rise .

28. Unit of
output
Total
variable
cost
Change in total
variable cost
0 0 0
1 10 10
2 18 8
3 24 6
4 28 4
5 32 4
6 38 6

29. Total Average Cost
Per unit cost of a good is called its average
cost .
AC=TC/Q
Average cost is composed of two types of
costs
in the short period :
(i) Average fixed cost (ii) Average variable
cost
AC=AFC+AVC

30. Average cost
Average fixed cost Average variable cost
Average fixed cost is
equal to total fixed
cost divided by
output ; i.e.,
AFC=TFC/Q
Average variable
cost is total variable
cost divided by
output . That is ,
AVC=TVC/Q

31. Outp
ut
TFC AFC
1 10 10
2 10 5
3 10 3.3
4 10 2.5
5 10 2
6 10 1.7
7 10 1.4
Output TVC AVC
1 10 10
2 18 9
3 24 8
4 28 7
5 32 6.4
6 38 6.3
7 46 6.6
8 62 7.8

33. Marginal cost
Addition made to the total cost by the
production of one more unit of a commodity
is called marginal cost . Its formula is :
MCn=TCn-TCn-1
OR

34. Output TC MC
0 0 -
1 20 20-0=20
2 28 28-20=8
3 34 34-28=6
4 38 38-34=4
5 42 42-38=4
6 48 48-42=6
7 56 56-48=8

36. Costs in the Long-Run
Each firm operates under short-run production
conditions , but it formulates long-run
production plans . In order to know about the
production plans of a firm , it becomes
essential to study longrun
cost .
No cost is fixed in long-run . All costs
becomes variable costs in this period . As in
the case of short-run , there are 3 concepts of
costs in the long-run also ,namely ,
(1)Long-run total cost(LTC) ,
(2)Long-run average cost (LAC) ,
(3)Long-run marginal cost(LMC) .

37. Long Run Total Cost
* The long run total cost curve shows the
total cost of a firm’s optimal choice
combinations for labor and capital as the
firm’s total output increases.
* Note that the total cost curve will always
be zero when Q=0 because in the long run a
firm is free to vary all of its inputs

39. Long Run Average Cost
The Long Run Average Cost, LRAC, curve
of firm shows the minimum or lowest
average total cost at which a firm can
produce any given level of output in the long
run (when all inputs are variable).

41. Long Run Marginal Cost
LRMC is the minimum increase in total cost
associated with an increase of one unit of output
when all inputs are variable. The long-run marginal
cost curve is shaped by returns to scale, along-run
concept, rather than the law of diminishing
marginal returns, which is a shortrun concept.

43. Conclusion

In short, Cost is expenditure incurred for
various factors of
production. Cost concept is used to
analyze two things: (a) short-run decision
making. (b) long-run decision
making. Cost curve is a graph of cost of
production which helps to determine
profit