Historical costs: When cost are calculated for a firm’s income tax returns, the law requires use of historical costs or the actual cash outlay.

Current costs: current cost is the amount that must be paid under prevailing market conditions.

Historical cost measure the market value of an asset at the time of purchase. Current cost measure market value at the present time. Historical cost is incurred at the time of

procurement Replacement cost is necessary to replace

inventory

Replacement cost: current costs for computers and electronic equipment are determined by what is referred to as replacement cost or the cost of duplicating productive capability using current technology.

• Opportunity cost is the value that is forgone in choosing one activity over the next best alternative.

Opportunity cost can be defined as the cost of any decision measured in terms of the next best alternative, which has been sacrificed. To illustrate the concept better, let us assume that a person who has Rs. 100 at his disposal can spend it on either of the three options: having a dinner at a restaurant, going for a music concert or for a movie. The person prefers going for a dinner rather than to the movie, and the movie over the music concert. Hence, his opportunity cost is sacrificing the movie, the next best alternative once he goes for a dinner. If we carry forward the same example at the firm level, a manager planning to hire a stenographer may have to give up the idea of having an additional clerk in the accounts department. This is applicable even at the national level where the country allocates higher defense expenditures in the budget at the cost of using the same money for infrastructural projects. In order to maximize the value of the firm, a manager must view costs from this perspective

Extending the concept of opportunity costs discussed above, total costs for a business should ideally include a normal payment for all the factors of production, including managerial and entrepreneurial skills and capital provided by the owners of the firm. A normal return to management or capital is the minimum payment necessary to keep those resources from shifting to other firms. Hence, economic cost refers to the costs involved for all the factors of production including those purchased from outside as well as those owned by the firm. For example, an entrepreneur wants to start a business with Rs. ten lakh, which is presently invested in a fixed deposit in a bank earning an interest of Rs one lakh per annum. Hence, while calculating the total cost of the firm the money earned as interest (Rs. one lakh) would be treated as economic cost.

In most business decisions, the total opportunity costs cannot be accounted for fully because of our inability to include implicit costs. Implicit costs are the value of forgone opportunities that does not involve a physical cash payment. For example, an entrepreneur who manages his firm has to forgo his salary, which he could have earned if he had worked elsewhere. Though implicit costs are not included in books of accounts, they do play an important role in a decision making process.

Explicit costs can be defined as the costs which involves actual payment to other parties. Both costs are equally important while making business decisions, but sometimes implicit costs are ignored as they are not as apparent as explicit costs.

There are two types of cost associated with time Incremental cost is the total additional cost that a

firm has to incur as a result of implementing a major managerial decision. For example, for Telco, a leading truck manufacturer in India, the marginal cost of making one additional truck in a defined production period would be the labor, components, and energy costs directly associated for making that extra truck. Incremental costs in this case would be adding a new product line, acquiring a company or hiring an in-house legal staff. Thus, it can be said that marginal cost is a subset of incremental cost.

Sunk costs are those costs which are incurred in the past or that have to be incurred in the future as result of a contractual agreement. The cost of inventory and future rent charges for a warehouse that have to be incurred as a part of a lease agreement are examples of sunk costs. These costs are irrelevant while making decisions because in any case they have to be borne by the firm.

Direct costs are the costs, which can be directly associated to the production of a given product. The use of raw material, labor input, and machine time involved in the production of each unit of that product can be determined.

On the other hand, there are certain costs like

stationery, office and administrative expenses including electricity charges, depreciation of plant and buildings, and other such expenses that cannot be separated and directly attributed to individual units of production.

Fixed costs are those costs, which do not vary with the changes in the output of a product. They are associated with the existence of a firm’s plant and, therefore, must be paid even if the firm’s level of output is zero. Costs incurred as a result of payment of interest on borrowed capital, contractual rent for equipment or building, depreciation charges on equipment and buildings, and the salaries of top level management and key personnel are generally fixed costs. For example, a firm which has entered into a lease agreement for ten years for hiring the office space has to pay the same rent whether the level of output of the firm doubles or even becomes four times in that ten year period.

Variable costs are those costs that vary with the level of output. They include payment for raw materials, charges for fuel and electricity, payment of wages and salaries of temporary staff, and payment of sales commission, etc. For example, in the case of hotel industry there is a high variation in occupancy rates according to different seasons. A hotel on a hill station may report 100 percent occupancy in summers while the situation changes dramatically in winters when the occupancy rates are just 10-20 percent or even lower. Hence, the industry hires lot of temporary staff during the period of high occupancy, who are not retained during low occupancy periods.

Average cost is the cost per unit.

Marginal costs can be defined as the change in the total cost of a firm as a result of change in one unit of output. These costs are important in short-term decision making of the firm to determine the output at which profits can be maximized.

Total cost (TC) is the cost associated with all of the inputs. It is the sum of TVC and TFC. TC=TFC+TVC

A cost function determines the behavior of costs with the change in output. The cost-output relationship gains importance when the firm has to allocate resources and determine a price for the output. The cost function can be a schedule, graph or a mathematical relationship showing the minimum achievable cost for producing various quantities of output. It indicates the functional relationship between total cost and total output. If C represents total cost and Q represents the level of output, then the cost function is represented as C = f (Q).

the total cost (C) for producing the output level Q is given by

C=L w + K r or C= f (Q)

Short run cost functions help in determining the relationship between output and costs in the short run. With a particular change in production output, the change in total, average and marginal costs can be determined for a given set of cost functions for a firm. The short run average total costs (SRATC) and average variable costs (AVC) are slightly U-shaped. The marginal cost (MC) curve intersects both the average variable cost curve and short run average total cost curve at their lowest points. The cost functions shown in the figure are the representative of the short-run costs incurred by majority of firms.

The level of output where the average total cost is minimum is known as the short run capacity of a firm.  This is also the optimum level output since the average total cost is minimized at this point .

No.of Output

TFC TVC TC AFC AVC AC MC

0 50 501 55

2 58

3 60.5

4 63

5 65

6 68

7 72.5

8 78

Long run can be defined as a sufficiently long period that allows the firm to adjust factors of production to meet market demand. In the long run, the firm chooses the combination of inputs that minimizes the cost of production at a desired level of output. The firm identifies the plant size, types and sizes of equipment, labor skills and raw materials that on combination give the maximum output at the lowest cost, considering the technology available and the production methods used. As the inputs are chosen for producing a desired level of output, all the inputs in the long run are variable. If there is an unexpected rise in the demand and the firm wants to increase the output from Q1 to Q2 (Ref Figure 5.2), the firm can increase variable inputs like labor and raw material. In such circumstances, the short run average cost will be high. If the demand lasts for a longer period, then a larger investment in the plant and equipment is required. This would reduce the per unit cost to C2. A short run average cost function like SAC2 can be determined for the new set of inputs.

Revenue is the income received from the sale of receipts or goods.

Concepts of revenue: Total revenue is the sum of the income received

from the sale of total goods.TR = price x quantity

Average revenue is the revenue per unit.AR = TR / No. of units sold

Marginal revenue is the additional revenue obtained by selling one more additional unit.

MR = change in TR / change in units sold

In perfect competition market AR = MR. In imperfect Competition market, AR >

MR

Break-even analysis is an important practical application of the cost function. In business planning, many decisions are taken on the basis of an anticipated level of output. Break even analysis studies the inter-relationships between the firm’s revenues, costs and operating profit at various levels of production. It is used to measure the effects of changes in selling prices, fixed costs, and variable costs on the output level that is to be achieved before the firm starts earning operating profits. Break even analysis is also used for evaluating the financial viability of new marketing plans and product lines. While conducting break even analysis, the level of output that a firm must produce to reach a point where the firm makes no profit or loss is known as break even point.

The difference between the total revenue and the total cost is the profit generated by the firm. In Figure 5.3, the vertical distance between the curves of total revenue (TR) and total cost (TC) determines total profits at any level of production. The point where the total cost equals the total revenue is known as the break-even point as explained earlier. In Figure 5.3, the break-even points can be seen at two different levels of production i.e. Q1 and Q3. Output below Q1 will lead to losses, as the total revenues are less than total costs. The firm earns profits between the Q1 and Q3 level of production, where the total revenue is more than the total cost. The total profits are maximum at point Q2 as the vertical distance between the total revenue and the total cost is maximum at this point. Therefore, to achieve the maximum level of profits, the firm should retain the same price-output structure

© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin

To maximize profit, a producer finds the largest gap between total revenue and total cost.

ProfitTotal CostShort-run

($)Revenue

Total

MinuteRakes per

Output:

STCTRQ

-36360.000

-194425.001

24850.002

245175.003

4456100.004

6263125.005

7872150.006

9184175.007

99101200.008

99126225.009

84166250.0010

A computer chip-manufacturing firm has incurred a fixed cost of Rs 2,30,000. It sells each unit for Rs 400. The variable cost per unit is Rs 65. What will be the break-even quantity and revenue?

Solution Quantity required to break even (Qb) = Fixed

cost/P – AVC = 23, 0000/400   – 65 = 23, 0000/335 = 686.567 units Or 687 unitsTotal revenue at which the computer chip

manufacturerbreak-even is equal to the product price and the

breakeven quantity.

 =687 * 400=  Rs 274800