COST

THEORY
BY - ARSHIA JANGRAL (24BC494)
PRAHARSH THAPLIYAL (24BC415)
AKSHAY KUMAR (24BC514)
YOSHA AWASTHI (24BC578)
OVERVIEW
INTRODUCTION DEFINITION TYPES OF FIXED VS
TO COST THEORY OF COST COST VARIABLE COSTS

RELATION BETWEEN TOTAL ECONOMIES OF DISECONOMIES

MARGINAL COST AND AVERAGE COST SCALE OF SCALE

COST THEORY IN
CONCLUSION.
DECISION MAKING
01

INTRODUCTION TO
COST THEORY
The economic cost theory explores a firm's level
of production in relation to its cost of outputs
throughout its activities.
It encompasses fixed and variable costs, average
and marginal costs, and how these affect pricing
and output.
The theory is important for businesses in deciding
the level of output that would lower production
costs and increase the profit margin.
The understanding of cost behavior assists
organizations in formulating budgets, making
forecasts, and developing strategies aimed at
appropriate distribution of resources.
PAGE 02
02

DEFINITION OF
OPPORTUNITY COST 1 COST
Cost is defined as those expenses
SUNK COST 2 faced by a business in the process of
supplying goods and services to
consumers.
INCREMENTAL COSTS 3

FIXED COSTS 4 TYPES

OF COST
VARIABLE COSTS 5
03

TYPES OF COST
1. OPPORTUNITY COST

Opportunity Cost is the loss of earnings due to

lost opportunities. The opportunity cost may be
defined as the loss of expected returns from
the second use of the resources foregone for
availing the gains from their best possible use.

FOR EXAMPLE - A person spending time and

money on watching a movie, they can’t spend
this time and money doing something else
04

2. SUNK COST
The cost that an entity has incurred, and which it can
no longer recover by any means. Sunk costs should not
be considered when making the decision to continue
investing in an ongoing project, since these costs
cannot be recovered.

FOR EXAMPLE - Salary for employees who have been

laid off.

3. INCREMENTAL COSTS-
Denotes the total additional cost associated with the
marginal batch of output. These costs are addition to
the costs resulting from a change in the nature and
level of business activity.
05

4.FIXED COSTS
A fixed cost is a business expense that normally doesn’t
change with an increase or decrease in the number of
goods and services produced or sold by the business.

Fixed costs are commonly related to recurring

expenses not directly related to production, such as
rent, interest payments, insurance, depreciation, and
property tax.

5. VARIABLE COSTS
Variable costs are expenses that vary in proportion to
the volume of goods or services that a business
produces. In other words, they are costs that vary
depending on the volume of activity.
06

OPPORTUNITY COST SUNK COST

Definition: Opportunity cost measures Definition: Sunk cost refers to already
the benefits of foregone opportunities. invested resources that cannot be
Focus: Opportunity cost focuses on the recovered.
future, considering the potential Focus: Sunk cost focuses on the past,
benefits of alternative uses of considering resources that have
resources. already been invested.
Impact on Decision-Making: Impact on Decision-Making: Sunk
Opportunity cost encourages cost can sometimes lead to sunk cost
decision-makers to consider the fallacy, where decision-makers
potential benefits of alternative continue to invest in a project
courses of action, which can help because of the already invested
avoid the sunk cost fallacy and resources, even if it is no longer the
maximize potential benefits. best course of action.
06
07

Examples of Opportunity Cost

Fran's Fountain Pens wants to expand and add a new location because their
business is doing well.

Location: Main Street Location: Maple Street

Monthly Rent: $3000 Monthly Rent: $2500

They'd attract the same number of customers in either location.,

In this situation, Fran's Fountain Pens chooses a storefront on Maple Street to save on costs.
THE OPPORTUNITY COST OF RENTING OUT MAPEL STREET WAS $500.
08

FIXED COSTS VARIABLE COSTS

Definition: Costs that remain Definition: Costs that change
constant regardless of with production levels
production levels Behavior with Production:
Behavior with Production: Do Increase or Decrease directly
not change with the amount with production volume.
produced. Time Frame: Short Term and
Time Frame: Long-term can fluctulate frequently.
commitments, often Impact on Profitability: More
contractual. flexible; help manage
Impact on Profitability : Higher expenses in response to
risk during low sales; can sales changes. .
enhance profitability at high
sales.
09

EXAMPLES OF FIXED COSTS AND VARIABLE COSTS

Rent for office space or Delivery/shipping charges
storefront
Sales commissions
Weekly payroll
Advertising and publicity
Equipment depreciation
10

MARGINAL COST
Marginal Cost is a key concept in
economics and cost accounting
that refers to the additional cost
incurred when producing one more
unit of a good or service. It is an
important measure for businesses
as it helps in decision-making
regarding production levels, pricing,
and profitability.
11

Significance of Marginal Cost in Production

1. Optimal Production Level: Helps determine
the profit-maximizing output level where
marginal cost equals marginal revenue,
guiding production decisions.
2. Pricing Decisions: Informs pricing
strategies; if the price exceeds marginal
cost, producing more units is profitable,
while the opposite may require
reevaluation.
3. Cost Control and Efficiency: Identifies
inefficiencies in production and aids in
managing costs, allowing businesses to
optimize operations.
12

Relation Between Total Cost and

Average Cost
Average cost is a function of total cost.

As production levels change, total cost

will increase or decrease based on
variable costs,

While average cost will reflect how

those changes affect the cost per unit.
13

Economies Of Scale
Economies of scale refer to the cost
advantages that a firm experiences as it
increases its production scale.
These advantages arise because fixed
costs are spread over a larger number
of units, leading to a decrease in the
average cost per unit.
Firms can achieve economies of scale
through various means, such as bulk
purchasing, improved operational
efficiency, and better utilization of
resources.
14

Types Of Economies Of Scale

INTERNAL ECONOMIES OF EXTERNAL ECONOMIES OF
SCALE SCALE
Technical Economies: Better utilization of Industry Infrastructure: Improved infrastructure, such
machinery and technology, leading to increased as transportation and communication networks, that
production efficiency. benefits all firms in the industry.
Managerial Economies: Improved management Supplier Specialization: Availability of specialized
practices and specialization in tasks. suppliers and services tailored to the industry’s needs.
Financial Economies: Access to better financing Labor Market Pooling: Access to a larger pool of skilled
options and lower interest rates due to larger labor, making it easier to hire employees with specific
scale. expertise.
Marketing Economies: Reduced advertising costs Technological Advancements: Industry-wide
per unit through bulk marketing and larger technological improvements that benefit all firms.
market presence.
15

Diseconomies Of
Scale
Diseconomies of scale occur when a firm
expands beyond its optimal size, leading to
an increase in average costs per unit.
This happens due to inefficiencies that
arise from managing a larger operation,
such as communication breakdowns,
bureaucratic delays, and managerial
challenges.
As a result, the benefits of increased
production are offset by rising costs,
reducing overall efficiency and
profitability.
16

Types Of Diseconomies Of Scale

INTERNAL DISECONOMIES OF EXTERNAL DISECONOMIES OF
SCALE SCALE
Managerial Inefficiencies: As a firm grows, it Resource Depletion: As more firms enter an
becomes more difficult to manage operations industry, the competition for limited resources
effectively. Decision-making can slow down and such as raw materials and skilled labor increases.
coordination among departments can become Increased Pollution and Congestion: The
complex. expansion of an industry can lead to
Communication Breakdown: Larger firms often environmental degradation resulting in higher
face challenges in maintaining effective costs for firms to comply with environmental
communication across different levels of the regulations and to manage logistics.
organization. Miscommunication can lead to Higher Wage Demands: A larger industry may lead
errors and delays. to increased demand for skilled labor, pushing up
Labour inefficiency: When a firm expands its wages and labor costs.
production capacity, work areas may become Regulatory Costs: Growing industries may attract
more crowded leaving little space for each worker more government scrutiny and regulation,
to work efficiently. increasing compliance costs for firms.
17

Cost Theory In Decision Making

Cost theory plays a crucial role in various aspects of business decision-making,
particularly in pricing. Cost theory helps firms determine the optimal pricing strategy
by analyzing production costs, market demand, and competition. By understanding
both fixed and variable costs, businesses can set prices that cover these costs and
ensure a profit margin. Pricing decisions are influenced by:

Cost-Plus Pricing: Adding a markup to the cost of production to ensure

profitability.
Marginal Cost Pricing: Setting prices based on the marginal cost of producing an
additional unit.
Competitive Pricing: Adjusting prices based on market conditions and
competitor pricing.
18

Conclusion
In conclusion, cost theory is a fundamental aspect of
economic analysis that provides valuable insights into the
behavior of firms and the efficient allocation of resources.
Understanding the principles of fixed and variable costs,
economies of scale, and the cost curves enables
businesses to make informed decisions that optimize
production and profitability.
As we navigate through the complexities of modern
markets, the application of cost theory remains crucial in
driving strategic planning and fostering sustainable
growth.
By integrating these concepts into our practices, we can
better anticipate challenges, seize opportunities, and
achieve long-term success in an ever-evolving economic
landscape.