Theory of Cost

5Theory of costEconomic cost has 2 main components01 Explict /direct /financial/accountung costOZ Implicit / indirect costAccounting costTotal amount of cost 5 be married by the firm in buyingresources outside of the Firm.eg- solemes for laborscost of row materialinterest payments for bank loansamortization payments02) Indirect costOppurtunity cost of resources owned by owners/firm.eg-: Normal profit @ apovment- Minimum expected retain of the contrepreneur in order toretain in existing industry- Opportunity cost of the cuntrepreneurlime value Forgone salery, Forgone profit 2leisure timeitemNormal profit may consist various items B. oadly that IStime value of the cuntrepleneurIf you think specifically it may be forgone salery, forgoneprofit, both, leisure time.Opportunity cost of capital equipments of owners- This has a main componentsOL Forgone interestO2 Economic depreciationRATINA OD Forgone interestAmount of interest income possible to be earned if theamount of money spent m buying capital equipments hadbeen invested in the financial market02) Economic depreciationDecreasing the market value of the capital equipments of owner Sduring a particular period of timewhenOppurtunity rentForgone rent of capital equipments and natural properties owned bythe Firmeg- opportunity cost of land / buildingThere's no point to calculate both opportunity rent and oppurtunity costtogether-Explicit cost is also having on oppurtunity cost which is equal to theFinancial value.-There's an oppurtunity cost OF resources owned by owners and it IScalled implicit cost.-Explicit and implicit costs, sum of both costs are called as oppurtunitycost of all resources-This is also known as economic costsEconomic - Opportunity cost of Explicit + ImoratCOSE to sall resources to costcost Total revenue - Accounting cost = Accounting profitTotal revenue - Economic cost . Economic profitAcc profit is importent in order to compute total profit of current-operational activities before taxes.absolute currentCACC profit IS importent to measure the success of operationalactivities)-Economic profit is importent in making policy decisions such ascurrent business should be shut down / continues/ resources should betransferred into another industry.eg-% Accounting profit and economic loss- NO fault with manager- Blame has to be caken by euntrepleneur since he hasn't select-ed the best option, now he have to transfer his resourcesto another industry / business.Behaviour of short run costShort run cost conceptOI Total fixed costcost of production that could be seen even at zero level of outputcost which doesn't change as the change in quantity OFoutputeg-: cost of capital equipmentswoinsurance premiuminterest For bank loansSPORTOnormal profitRATINAsaleries for contracted labours 20102 Total vanable cost -TVCTotal amount of cost that directly change as change inquantity of outputO.3 Total cost - TCTotal cost to be incurred by the fitm in producing particularquantity of outputTC - TFC+TVC4 Average Fixed cost. AFCfiredTotal cost per unit of outputAFC - TFCeos Average variable cost AVCTotal variable cost per unit of outputAVC . TVCQ06Average Total Cost ATC / LACTotal Cost per unit of outputAC = TCaATC = A.FC + AVCof Marginal cost - MCChange in total cost as a result of changing one unitof output C Change in TVC.)MC - DQ ATC = MCC - D DQ TVC Graphical illustrations of shot run cost conceptscostTCT.V.CTFC0OTVC starts from organ - Because TVC IS zero at zelo quantity of outputTVC is rising at decreasing rate at the begining and then risingat increasing rate beyong a particular limit Because of the lawof diminishing marginal returnsvanableAt the begining productivity of, resources is high since there'senough capacity. But later amount of Fixed resource wouldnot be enough to absorb the variable resourcesTC starts at the intersection of vertical axis of TFC at zero quantityOF output TC = TFCTC curve also have the same behaviour of TVC TUCHS a compone-nt inside the TCis30 givenMOSTO to eri, institutcompany eldown o copiegebaxit ToRATHNA DateCostMCATCAVCAFC@Q.P.Reasons for individual behaviour of cost curvesDAFCAFC IS conunuously falling because TFC per unit of quantity of outputdecreases when quantity of output increases while having fixed valuefor TFC2ATC D AVC, MCThese are falling as quantity of output increases and beyond ceitanpoints rising The reason IS the law of dimmishing returns3)U shapes of ATC,AUC,MCAt the begining productivity of variable resources increases as quantityof output increases. Beyond certain pames because there's well sufficientquantity of fixed resourceswhen the quantity of output increases continously beyond certainpoints productivity of vonable resources decreases F because of haunginsufficient amount of fixed resources Therefore curves are risingBATHMA Relationships among cost curvesolVertical distance between ATC and AVC gradually (decreasesBecause of continious reduction of AFCO Q1ATC = AVC + AFCQ1 - Q2ATC . AVC + AFC&The rate of decreasing AFC is greater than the that of increasing AVC.Here law of chmmishing marginal retuins is not powerful.QsATC - AVC + AFCHere law of diminishing marginal retains IS very powerful due to thefixedinsufficient resources Relationship between production and case curvesQMPLAPLLOL1L2costAVCMCoPisQ2APLrMathematical explanationAVC= TVCAVC= 3AP: - QQARLAVC - W.LAVCWso,@APLeAPLAVC= W. LS. 000Q200>" ONSuppose wage late 15 constanc, when decreasing APL 7 Ave is increasingand when increasing APL. AVC 15 decreasing when AP is maximised . AVC isminimisedwarne APLMC. ATC02MC ATUCDQMC. (C.W.L)soMP DRDLMC. W. OLofDLMC = W. I02 MPLMPLMC WMP,Suppose wage rate is constant 15 short run. when decleasing AMPL a MCIS increasing and when increasing MPL , MC IS decreasing whome subs.titute the maximum output of Labour MC is minimised.Long run costLong run total cost curve-In long run, all resources-die vallable resources-So, all the types of costs are vanableTC (total`cost) is starting from the origin since there's no fixed-cost in long runAt zero level of output total cost 75 2010-At the begining of long Jun, when the Firm IS expanding its scale-LTC is insing at decreasing rate initially and bhenlising at increasingEconomies of scaleDiseconomies of scalerate CostLTC (Long uncast curve)eRelationship between long run cost curvescostLTCQOQ1Q2CostLMCLATCQ :LATCSATCSATCSSATCSATC3SATCLATC0e-There is a shorts run average total cost curve, couching each. and everypoint on LATC.-Except a one SATC C SATC-3) all the SAT curves touches the LATC bya point which IS beyond its mirmized pant/ minimum point-Left hand side of minonum point of LATC, producing in long run has acost savings rather than producing in a some plant size-At the begining of long iun LATC IS Falling which implies unit costor average total cost can be reduced by expanding the scale.Beyond a particular point in long run LATC is rising which imphes thataverage total cost or unit cost IS increasing if the scale ISexpanded.SATC3 13 the optimum plant size:Because when expanding the plant size becond this point IS notappropriate: New SATC'S minimum point = LATC's minimum point-Decreasing of LATC is called as, Economies of scaleRising of LATC IS caled as, D seconomies of scale--BATHNA 20Economies of scaleReduction of LATC as a result of expanding the plant size orscale of the business.Reasons for economies of scale1.Technical2. Marketing3. Financial4.Manegenal5.Risk bearingOI) Technological economies of scale-Decrease in A.C. in long run due to balization of optimum level ofthe plant sizeC Due to utilizing optimum level of some resources )eg-+Burgermaster sofasetCapacity of high talented and high experiencedmanager can be utilized fully in long run.02 Marketing economies of scale-Decrease in ATC in long run due to efficiencies experienced by thefirm in marketingeg: Decrease in per unit advertising and promotional costin long run.Decrease in per unit cost due to laroe scale discountsDecrease in per unit transport and distribution cost dueto expanding the scaleNATINA 03) Financial economies of scaleDecrease in ATC in long run due to ability of suppluibs loans/Funds bollowings comparatively at a lower costeg- Dispanty of bollowing cost between formal and informalfinancing method.Barganing power of large scale organisations result inlow borrowing costs. low interest rates and law proceduresand time to set loans/ fundsMethods such as issueing shares can be used04Manegenal economies of scale-Decrease in ATC in long run due to advantages of division oflabour and specialization `experienced by a Firm in long ion.eg: Having sectors according to the functions of the organi-sationc Product/Maiketing/HRM/Mitreting /IT)OSRisk bearing economies of scale-Decrease in ATC in long run due to ability of bearing riskeg-t-A large scale Firm can use product divercity successfullyThis results in decrease.in ATC since the wastage isminimised and the risk of selling products IS lowDiseconomies of scaleIncrease in Long run average total costReasons for diseconomies of scaleIManegerral inefficiencies-Increase in ATC in long run due to manegenal inefficiencespossible to produced. by overexpansion of the plant size.-Break down of cordination overload of manegerial capacityRATHMA 2.Labor inefficiencies-Increase in ATC in long run due to inefficiencies of laborutilization-Disadvantages of overspecialization results in decrease in laborproductivityeg- mental stress - boredom3Marketing inefficiencies-Increase UT ATC in long run due to inefficiencies experienced bya firm in long run related to marketing activities-eg Increase in per unit advertising cost due to the huge andunnecessary competition in the market (Lux)4Financial inefficiencies-Increase in ATC in long run due to inefficiencies experienced bya to Frm due to financial inefficiencies.eg- Rate of interest increases due to increase in demand forbonowings if large scale business firms are operatingin the long run.S.Environmental degration / factorsDecrease in quality of environment-Increase in ATC in long run due to environmental problemscreated by large scale business Firmseg 20 when many businesses ate clustered in a one zoneit results in traffic, high fuel cost , high amount oftime wastage C colombo)Depreciation of key natural resources results UP! utilizationof substitutions which are low in quality (medicines)RATHNA