Cost Function

Unit – 6
Dr. Malini N
Week 6 Production Function

Quadrant 1 1. Watch the eLearning content on ““L5: Production Function” ” before the live session.
eContent 2. Read the e-LM on “Unit 6: “L5: Production Function” ”

Quadrant 2 1. Revise the “L4: Demand Forecasting” recording of the live Session
e-Tutorial 2. Attend live session #6 on ““L5: Production Function” ”

Quadrant 3 1. Take the formative assessment for ““L5: Production Function” ”

e-Assessment 2. After the live session, repeat the formative assessment for “L6: Organizations and Organization Theory” for
self-assessment
3. Attempt solving the Practice MCQs & Case Study #6 on ““L5: Production Function” ”

Quadrant 4 1. Participate in collaborative learning by discussing the Practice MCQs

Discussions
 Unit – 6
Cost Function
• Topics:
• Introduction,
• Basic cost concepts,
• Types of cost,
• Cost output relationship in short run
• Cost output relationship in long run,
• Breakeven analysis
Meaning of Cost

• Cost refers to the amount of expenditure incurred in acquiring

something or it is the expenditure incurred to produce an
output or provide service.
• Thus, the cost incurred in connection with raw material, labour,
other heads constitute the overall cost of production.
 Meaning of Cost Analysis
• Cost analysis involves determining the costs incurred for inputs
and how they affect the output or productivity of a company.
• Cost analysis also involves breaking down a total cost into its
different constituents and studying each cost component.
• Cost analysis also involves the comparison of costs for making
improvements in future. For example: comparing the standard
cost with actual cost.
Cost Concepts
• Actual and Opportunity costs
• Implicit and Explicit costs
• Fixed and Variable costs
• Accounting and Economic costs
• Short-run and Long-run costs
Actual and Opportunity costs
• Actual costs are the costs incurred on producing a certain
quantity of goods or providing a certain service. These costs are
recorded in the books of accounts and are used for financial
analysis.
• Opportunity cost is the cost of the next best alternative/choice
that is forgone. These costs are not recorded in the books of
accounts.
Implicit and Explicit Cost
• Implicit costs, as the name suggests, are implied costs. This
means an implied cost is not an actual expense or cost incurred
but a reduction in revenue. This reduction in revenue is a loss
incurred due to the event or an action. However, as there is no
actual money spent, it does not get recorded in the books of
accounts.
• Explicit costs are the actual expenses or costs incurred and these
are recorded in the books of accounts. They are also called actual
costs. For example, costs incurred on the purchase of raw
materials, paying wages and salaries to workers, and paying rent.
Fixed and Variable costs
• Fixed costs are expenses that are fixed in nature. It means that
fixed costs do not fluctuate according to production and are
incurred by the business even if it is not producing anything. For
instance, rent of the building is a fixed cost.
• Variable costs are the costs that vary with the amount of
production or output. These costs can include raw materials,
water, labour, etc. It depends on the usage. For example, a
construction site requires more workers while constructing the
building.
Accounting and Economic costs
• Accounting costs also called money costs, include all actual
expenses, depreciation expenses and all regulatory expenses as
per law.
• Economic costs include opportunity costs, implicit costs in
addition to the actual and explicit costs.
• In case the office space is owned by the business, the accounting
cost would show zero rent for the space used. But the economic
cost will show the rent of the office space as opportunity cost
foregone as the space used by the business and has not earned
rent if it would have let it out.
Short-run and Long-run costs
• In short-run, one factor of production is fixed. Short-run is
usually considered for up to one year.
• For example, if the capital employed (factor of production) is
fixed, then, for increasing production in short-run, the business
cannot increase its capital but it will have to increase the number
of workers or machinery, etc. It is also possible that the business
would rent machinery instead of purchasing the machinery.
• In the long-run, none of the factors of production is fixed, they are
all variable. The time period for long run is usually more than a
year. Here the business has to consider the long-run impact and
plan accordingly.
Cost Function
• Acost function is a symbolic statement of the
technological relationship between cost and output.
• Itthrows light on cost minimization or profit maximization
and optimization of profit.
• The relation between the cost and output is technically described
as the “COST FUNCTION”.
• The general form of cost function is written as:
• TC = f(Q)
 Total, average & marginal  Fixed cost & variable cost
cost
1.Total fixed cost (TFC) = cost of
1. Total cost (TC) = TFC + TVC, rise using fixed factors = cost that does
as output rises not change when output is changed

2. Average cost (AC) = TC/output

2. Total variable cost (TVC) = cost of
using variable factors = cost that
3. Marginal cost (MC) = change in
changes when output is changed
TC as a result
of changing output by one unit
 COST FUNCTIONS

SHORT RUN LONG RUN

FUNCTION
FUNCTION
 Short-run TC

TVC TFC
Normal profit

Salaries of Fixed Depreciati

Labour Raw Running administrativ expen on of
costs materials expenses of e staff paid on ses of fixed
which machinery a fixed basis plant capital
vary
with
output
 SHORT RUN FIXED COST
• Fixed cost are those cost which do not change with changes
in output.

• Fixed cost are otherwise called ‘supplementary cost’ or ‘over

head costs’.

Ex: Rent on land and building, Insurance charges, Interest on

fixed capital, Salary of permanent employees.
 SHORT RUN VARIABLE COST

• Variable cost are those costs which changes with changes

in output.
• Variable cost are also called ‘prime cost’.
• Eg: cost of raw materials, cost of power in
production, wages of workers.
 SHORT RUN TOTAL COST
• Total cost is defined as the Total actual cost that must be
incurred to produce a given quantity of output.
• Fixed cost and variable cost are formally called Total fixed
cost and Total Variable cost.

TC = TFC + TVC
UNITS OF TFC TVC TC
OUTPUT [Rs.] [Rs.]
[Rs.]
0 60 60 -60 = 0 60

1 60 100 -60 = 40 100

2 60 120 – 60 = 60 120

3 60 70 130

4 60 100 160

5 60 160 220

6 60 300 360
SHORT RUN TOTAL COST CURVE
 TFC being fixed at Rs.60, remains
the
same at all levels of output. Thus,
the TFC- curve is a straight line parallel
to the
x-axis.

 TVC – curve starts from the origin at zero

output. It move upwards from left to
right.

 The shape of TC –curve is the same as

S H O R T R U N A V E R A G E COST

A V E R A G E F I X E D COST

SHORT R U N AVERAGE VARIABLE

AVERAGE COST
COST
A V E R A G E TOTAL
COST
 AVERAGE FIXED COSTS

• AFC is the per unit fixed cost of producing a commodity. It is

obtained by dividing the total fixed cost by the quantity of output
[Q].

AFC = TFC
Q
 AVERAGE VARIABLE COST
• AVC is the per unit variable cost of producing a commodity . It is
obtained by dividing the total variable cost by the quantity of
output.

AVC = TVC
Q
 AVERAGE TOTAL COST

• AC is the sum total of AFC and AVC.

AC =

T
C
SHORT RUN AVERAGE MARGINAL
COST CURVE
MARGINAL COST: Marginal cost is the addition to total cost by the
production of an additional unit of output.

Marginal Cost (MC) = TC/Q

MC = (TFC +TVC)/Q = TVC/ Q.
 TFC is zero in the short run.

TFC = Total Fixed Cost

TVC = Total Variable Cost
Q = Output
AFC = Average Fixed Cost
AVC = Average Variable Cost
Units of TFC TVC TC AFC AV AT MC
producti [Rs] C C
on [Rs] [Rs] [Rs] [Rs] [Rs] [Rs]
O 60 0 60 - - - -

1 60 40 100 60 40 100 40

2 60 60 120 30 30 60 20

3 60 70 130 20 23.3 43.3 10

4 60 100 160 15 25 40 30

5 60 160 220 12 32 44 60

6 60 300 360 10 50 60 140

SHORT RUN AVERAGE MARGINAL CURVES

• The short –run MC curve will at first decline

and

intersects the ATC and AVC at their minimum points.

• The AVC curve will go down , and then go up.

• AFC curve will decline as additional units are produced

, and continue to decline.

• ATC curve initially will decline as the fixed cost are

spread over a large number of units , but will go up as

MC increase due to the law of diminishing returns.

Short Run Computation of Cost
Q TFC TVC TC MC AFC AVC ATC/SAC
0 240 0
1 240 70
2 240 130
3 240 180
4 240 220
5 240 250
6 240 270
7 240 294
8 240 360
9 240 495
10 240 700
Short Run Computation of Cost
Q TFC TVC TC MC AFC AVC ATC/SAC
0 240 0 240
1 240 70 310
2 240 130 370
3 240 180 420
4 240 220 460
5 240 250 490
6 240 270 510
7 240 294 534
8 240 360 600
9 240 495 735
10 240 700 940
Short Run Computation of Cost
Q TFC TVC TC MC AFC AVC ATC/SAC
0 240 0 240 -
1 240 70 310 70
2 240 130 370 60
3 240 180 420 50
4 240 220 460 40
5 240 250 490 30
6 240 270 510 20
7 240 294 534 24
8 240 360 600 66
9 240 495 735 135
10 240 700 940 205
Short Run Computation of Cost
Q TFC TVC TC MC AFC AVC ATC/SAC
0 240 0 240 - -
1 240 70 310 70 240
2 240 130 370 60 120
3 240 180 420 50 80
4 240 220 460 40 60
5 240 250 490 30 48
6 240 270 510 20 40
7 240 294 534 24 34
8 240 360 600 66 30
9 240 495 735 135 27
10 240 700 940 205 24
Short Run Computation of Cost
Q TFC TVC TC MC AFC AVC ATC/SAC
0 240 0 240 - - -
1 240 70 310 70 240 70
2 240 130 370 60 120 65
3 240 180 420 50 80 60
4 240 220 460 40 60 55
5 240 250 490 30 48 50
6 240 270 510 20 40 45
7 240 294 534 24 34 42
8 240 360 600 66 30 45
9 240 495 735 135 27 55
10 240 700 940 205 24 70
Short Run Computation of Cost
Q TFC TVC TC MC AFC AVC ATC
0 240 0 240 - - - -
1 240 70 310 70 240 70 310
2 240 130 370 60 120 65 185
3 240 180 420 50 80 60 140
4 240 220 460 40 60 55 115
5 240 250 490 30 48 50 98
6 240 270 510 20 40 45 85
7 240 294 534 24 34 42 76
8 240 360 600 66 30 45 75
9 240 495 735 135 27 55 82
10 240 700 940 205 24 70 94
 Meaning of Breakeven Analysis

Breakeven analysis is the business analysis performed to determine the probable point
when your business will be able to cover all its expenses and begin to make a profit.

Breakeven analysis can be done to determine either the breakeven point or the breakeven
volume.

In its narrow sense, BEP=Total Revenue – Total Cost i.e., the point of zero profit. It is the
point that above it, the business starts making profit (revenue exceeds costs), all factors
remaining constant.

In its broader sense, it denotes a system of analysis that can be used to determine the
probable profit at any level of operations.

According to Keller and Ferrara, “the break-even point of a unit of a company is the level of
sales income which will equal the sum of its fixed costs and its variable costs.”
 Perspectives of Breakeven Analysis
•
Breakeven point can be determined in terms of:
•
Time - how long will you be in business to be able to start making profit?
•
Units of sales – how many units of your product will you be able to sell
before making profit?
•
Sales revenue – how much revenue do you need to generate to start making
profit?
 Calculation of Breakeven Point

Breakeven
Analysis

Linear Cost and Non linear Cost

Revenue and Revenue
Relationship Relationship

Graphical Algebric Contribution Profit Volume

Method Method Analysis Ratio
Graphical Method
• Graphical Method shows a linear break-even analysis. When the
price of a product remains the same, the organization expands its
production, thus, total revenue is linear to the output.
 Algebric Method
• Algebraic Method helps in decision making problems of the organization. We
know that profit is equal to the difference between total revenue and total
cost.
• π=TR -TC
• TR=P*Q
• TC =TVC+TFC
• TC = AVC*Q + TFC (TVC is the average variable cost per unit multiplied by
the output produced and sold)
Problem 1
• Sales = Rs. 12000
• Variable Cost = Rs. 7000
• Fixed Cost = Rs. 4000
•Calculate the Contribution?
Solution:
C=S–V
C = 12000 – 7000
= Rs. 5000
Profit = C – F
=
5000
–
4000
Problem 2
• Calculate contribution in each of the following independent
situations:
1. Fixed cost Rs. 8000, Profit Rs. 5600
2. Variable cost Rs. 7000, Sales Rs. 11000
3. Contribution per unit Rs. 7, Profit Rs. 3000, B.E Point
2000 units
Solution
Sales
-VC
Contribution
-FC
Profit
Contribution = (Contribution per unit X BEP in units) + Profit
= 7 X 2000 + 3000
= Rs. 17000
Profit volume (PV) ratio
• Profit volume (PV) ratio refers to another method to find break-
even point. The formula for profit volume ratio is:
• PV ratio=(S – V)/ S * 100
• S = Selling price
• V = Variable costs
Problem
• Sales = Rs. 10000
• Variable cost = Rs. 8000
• Calculate the P/V ratio.
• Solution :
• P/V ratio = S-V/S * 100
• = 10000-8000/10000 * 100
• = 20%
Week 7 Production Function

Quadrant 1 1. Watch the eLearning content on “L5: Production Function” before the live session.
eContent 2. Read the e-LM on “L5: Production Function”

Quadrant 2 1. Revise the ““L5: Production Function” ” recording of the live Session
e-Tutorial 2. Attend live session #6 on ““L5: Production Function” ”

Quadrant 3 1. Take the formative assessment for “L5: Production Function” ”

e-Assessment 2. After the live session, repeat the formative assessment for “L5: Production Function” for self-assessment
3. Attempt solving the Practice MCQs & Case Study on “L5: Production Function”

Quadrant 4 1. Participate in collaborative learning by discussing the Practice MCQs & Case Study
Discussions