Cost of Production

Cost of Production Explicit cost: Includes all tangible expenses that appear in the account books - incurred through market transaction Implicit Cost- Does not appear in account books- own resources of entrepreneur- imputed cost Accountant’s cost considers only explicit cost whereas economist’s cost includes both

Cost of Production Private: All expenses including explicit and implicit costs incurred by a firm for purchasing or hiring resources Social: Cost which society bears on account of the production process- disutility such as deforestation, pollution… Externalities- positive and negative

Cost of Production • Short run costs : Costs incurred in the short run • Long run costs- Costs arising out of change in size and kind of output

Fixed cost: Cost incurred on fixed factors- remains constant at different levels of production-has to be incurred even if there is no production . E.g., rent, interest • Variable cost varies with output and is zero when there is no production E.g., material cost, transport cost

Opportunity cost: Cost of next best alternative foregone • Arises because of scarcity and versatility of factors of production

Production costs are the costs which are incurred to make a product, transport it and make it available to the consumer- costs of hiring resources, raw materials, energy, transport etc • Selling costs are those that are incurred for changing the demand and preference of consumers- on advertising, sales promotion, displays, free samples, salaries of salesmen etc

Short run Costs Short run Costs • TFC • TVC • TC=TFC+TVC • AFC= TFC/ No. of Units of output • AVC= TVC/ No. of Units of output • AC= TC/ No. of Units of output • MC= TCn - TC n-1

Short run Costs

Short run Cost Curves TC y TVC Total Cost TVC TFC TFC o x Output

Short run Costs Behaviour of Total Costs: • TFC is a horizontal straight line, parallel to X axis as it remains constant irrespective of output • TVC slopes upwards as output increases

Short run Cost Curves MC y AC Fixed cost is spread over a larger output AVC Cost AFC o x Output

Short run Costs Behaviour of Average Costs: • AFC: Falls as output increases- rectangular hyperbola- arithmetic result • AVC, ATC and MC: Decrease first, then rise • MC: Determined only by the rate of change in variable cost - independent of fixed cost • For the first unit, AVC= MC

Short run Costs • AVC decreases as firm expands and approaches optimum level of output. After plant capacity output is reached, AVC starts increasing. • AVC’s slope indicates increasing, constant and decreasing returns to variable factors • The lowest point of the U-shaped AVC occurs where the quantity of output has the minimum cost

Long run Cost Curves • Firms can change output by altering size of plant in the long run • All costs are variable in the long run • Long run is a relative concept-varies from industry to industry • Long period be divided into a number of short periods

Long run Cost Curves There will be a new SAC every time the scale is revised. Diagram depicts 3 such SACs. Y SAC 2 Cost SAC1 SAC 3 X 0 Output

Long run Cost Curves Envelope curve because it envelopes a series of short run curves Disk shape because of phases of increasing and diminishing returns It is also called planning curve LAC

I.Economic vs Accounting Cost • Consider a garment factory producing 100 shirts, using hired resources as given below: Labour (at Rs.2900), machines(2100), raw materials (Rs.1800) electricity (Rs. 700). The producer uses his own resources as follows: Land worth Rs. 5000, family labour worth Rs.3500, and his own truck (cost Rs. 1500) to transport materials. Work out the economic cost and accounting cost of producing 100 shirts.

Economic vs Accounting Cost Factors hiredCost in Rs Labour 2900 Machines 2100 Raw Materials 1800 Electricity 700 Accounting cost 7500 Self owned factors Cost in Rs Family Labour 3500 Land 5000 Transport 1500 10,000

Economic vs Accounting Cost Economic cost of producing a 100 shirts is Rs. 17500. Economic cost per shirt: Rs.175 Accounting costs of producing 100 shirts is only Rs. 7500. Accounting cost per shirt: Rs.75

SUM The cost of attending a private college for one year is $ 6,000 for tuitions, $ 2000 for room, $ 1500 for meals, and $ 500 for books. The student could also have earned $ 15,000 by getting a job instead of going to college and 10% interest on expenses she incurs at the beginning of the year. Calculate the explicit, implicit and total economic costs of attending college.

Approaches to Cost Reduction • Philip Young and John McAnley have categorised Cost Reduction methods as follows • 1. Budgetary Approach - Actual cost must be brought in line with the budgeted amounts- cutting costs to match the fall in revenue-Approach involves identifying items in the budget that are amenable to quick changes- travel is frozen, coffee and refreshments no longer served at meetings, etc

Approaches to Cost Reduction 2. Input Reduction Approach: “Doing more with less”- plant shut downs, early retirement offers, VRS 3. Input Cost Reduction Approach: Under this, managers try to reduce input cost in various ways- reduction of wage costs through offers of shares of company in exchange for lower wages; moving into offices costing lower rent or maintenance; searching for cheaper suppliers of materials

Approaches to Cost Reduction 4. Input Substitution Approach A company may consider building a plant in a foreign country to take advantage of lower wages 5. “Not Made Here” Approach: It may be decided that an outside vendor of service can supply at a cheaper rate than what it costs the company to produce- e.g., outsourcing

Approaches to Cost Reduction 6. Suggestion Box Approach- from employees, especially those who are connected directly with production process

Cost of Production