COST OF THE

CONSTRUCTION FIRM

Prof. (Dr) Vandana Bhavsar

 INTRODUCTION
If the business costs is taken into consideration the
importance of law diminishing returns is understood well.
Assume that a worker is paid Rs. 500 per week.
Thus MC in turn affects pattern of other costs......
Input of Total Product Marginal Physical Labour Cost per sq
Labour (output in sq. m Product (in sq. m mt (MC)
per week) per week
0 0 - -
1 20 20 25
2 60 40 12.5
3 120 60 8.33
4 140 20 25
5 150 10 50
6 160 10 50
7 165 5 100
8 163 -2 -250
 MEANING OF COSTS
Cost of production of a commodity means
the payments made to the factors of
production of the commodity.

It mainly depends on quantity of output.

Cost of production increases with the

increase in output.

Thus, C = f (Q)
 CLASSIFICATION OF COSTS
Money Cost the amount of money spent
in terms of money to produce a commodity
is called its money cost.

Real Cost refers to those payments

which are made to factors of production to
compensate for the total sacrifices &
efforts in rendering their services. It does
not carry any significance in the cost of
production because it is subjective concept
& lacks precision.
 EXTERNAL & SOCIAL COSTS
External Costs - A cost that is not borne
by the firm, but is incurred by others in
society is called an external cost.

Social Costs it is total of all cost of the

society irrespective of who bears it. It is
sum of private & external costs.

Thus,
Social Cost = Private Cost + External
Cost
HISTORICAL & CURRENT COSTS
Historical cost is incurred at the time of
procurement. It is actual cash outlay. For
tax purpose this is relevant.
Current Cost are more relevant since they
are amount paid under prevailing market
conditions. It is influenced by the number
of buyers & sellers, technology & inflation.
CURRENT COST > HISTORICAL COST
[not always]
Replacement cost is the cost of duplicating
productive capability using current technology. It
is necessary to replace inventory. This more
relevant for decision making purpose.
 Example
A construction co.
Inventory of 1 million board feet of wood,
purchased at a historical cost of Rs. 200
per 1,000 board feet
Assume that wood price rises by 50 %.
Company is asked to bid on a construction
project that would require wood.
What cost should company assign to wood
Rs 2,00,000 [historical cost] or Rs
3,00,000 [replacement cost]?
EXPLICIT V/S. IMPLICIT COSTS
Explicit costs include the ordinary items
that an accountant would include as the
firms expenses. Out-of-pocket cost or
explicit cost is actual transfer of value
that occur.

E.g. wages, utility expenses, payments for

raw materials, rent, interest.

Implicit costs include opportunity costs

of resources owned and used by the firms
owner. Non cash costs.
 INCREMENTAL COSTS
Incremental cost is the change in cost
caused by a given managerial decision &
often involve multiple units of output. It
varies with the range of options available in
the decision making process.
E.g. A real estate firm refuses to rent excess office
space for Rs 1000 per month because it figures
incremental operating cost of Rs. 700 + interest &
overhead charges of Rs 800.
It means there is loss of Rs. 300 [1000-700] per month
in profit contribution since interest & overhead will be
incurred irrespective of whether excess space is rented.
Incremental Cost = Explicit Cost +
Implicit Cost
 SUNK COSTS
Sunk cost does not vary with decision options.
Thus any cost not affected by a decision is
irrelevant to that decision.
Sunk cost is one that already has been paid, or
must be paid, regardless of any future action
being considered
Even a future payment can be sunk

E.g. A firm has spend Rs. 5000 on an option to

purchase a land at price of Rs 5 L. It is later
offered an equally attractive site for Rs. 4 L.
What should a firm do?
Rs 5000 is sunk cost for it.
 ECONOMIC COSTS
Economic costs include the opportunity
costs. Hence

Economic cost = Accounting Costs +

Opportunity Costs (explicit+implicit costs)

Hence, if an entrepreneur, who had been

previously employed sets himself up in business
and invest Rs. 50,000, then he will forgo the
interest he could have earned. He also forgoes
the income he would have earned. These are
both opportunity costs that we must include in
our calculation of economic costs.
 SHORT RUN COSTS
In short run firms incurs different types of
costs.
A firms short run costs are a reflection of the
law of diminishing marginal returns.
FIXED COSTS
costs that are not related directly to
production. They can change but not in relation
to output. Fixed costs are never zero.
VARIABLE COSTS
costs directly related to variations in output.
 A building firm XY.
Plant & machinery that a firm owns
Office buildings the company occupies,
Permanent staff,
Wear and tear of the machines
Pay to admin staff no matter how many houses it builds
However, most contractors have no factory-each site
represents the firms new work location
Much of necessary equipment is usually hired as and
when required
 FIXED COSTS VARIABLE COSTS

Rent Labour used on site

Insurance Materials used on site

Bank Interest & leasing Equipment used on site

costs
Head office bills for energy, Site management
water
Salaries to admin staff Tendering for future

Maintenance costs Variable portion of utility

charges
Sales commissions
 For construction firms the fixed costs are less
Whereas variable costs in construction tend to be
much higher
The more a firm builds or makes, the more labour it
has to hire and the more wages it has to pay.
As the size and number of the projects increases,
construction firms need to employ good site and
project managers.
These are short in supply and so it is difficult to
determine when variable costs will rise.
Distinction between fixed & variable costs depends
on how individual firm is organised.
If the firm depends more on subcontracting then it
can avoid large proportion of fixed costs.
 TOTAL COSTS
Total Cost - the sum of all costs incurred in
production
TC = FC + VC

Average Cost the cost per unit

of output
AC = TC/Output

Marginal Cost the cost of one more or one

fewer units of production TC
MC
MC = TCn TCn-1 units Q
MC for any change in output is equal to shape of TC
curve along that interval of output
 The fixed costs are spread over the output
to give Average Fixed Costs (AFC) &
these will reduce as output increases
AFC = TFC/Output

When there is no output the variable costs

are zero. Average Variable Costs (AVC)
are the total variable costs divided by the
amount of output
AVC = TVC/Output
 Numerical Example
Output TVC TFC TC MC* ATC AVC AFC
0 0 8500 8500
100 2500 8500 11000 25 110 25 85
200 3800 8500 12300 13 62 19 43
300 4800 8500 13300 10 44 16 28
400 6000 8500 14500 12 36 15 21
500 7500 8500 16000 15 32 15 17
600 9500 8500 18000 20 30 16 14
700 12500 8500 21000 30 30 18 12
800 17000 8500 25500 45 32 21 10.6
900 22500 8500 31000 55 34 25 9.4
1000 32500 8500 41000 100 41 32.5 8.5
* MC is per 100
TOTAL COST CURVES - SHORT
RUN
435
375 TC
315 TVC
RS 255
TFC

195
135

TFC
0 30 90 130 161 184 196
Units of Output
RELATION BETWEEN AC &
MC MC

3
ATC
AFC
Rs
2 AVC

0 30 90 130 161 196

Units of Output
 Relationship Between AC &
MC
At low levels of output, the MC curve lies below
the AVC and ATC curves
These curves will slope downward
At higher levels of output, the MC curve will rise
above the AVC and ATC curves
These curves will slope upward
As output increases; the average curves will first
slope downward and then slope upward
Will have a U-shape
MC curve will intersect the minimum points of
the AVC and ATC curves
An efficient firm will aim to achieve its output at
lowest point on AC
The Contractors Project Costs
In most cases clients in construction industry initiate
the projects
Contractor has to determine the price before the project
is completed.
In many cases there is Monopsony.
Clients invites contractors through bidding/tendering
Thus contractors estimate the price before the project is
complete
Hence they wont be certain of their costs.
 LONG RUN TOTAL COSTS
The long run cost curve shows the minimum
cost impact of output changes assuming an
ideal input selection.
Any change in operating environment [wage
rates, interest rates, plant configuration]
leads to a shift in long run cost curves.
E.g. Product inventions & process
improvements that occur overtime cause
downward shift in LRCC.
LRCC reveals the nature of economies or
diseconomies of scale and optimal plant sizes.
 LTC LTC
All inputs are variable in the
long run. There are no fixed
costs.
Long Run Total
Cost

Total Product Q

LONG-RUN TOTAL COST CURVE

 LONG RUN AC
The LAC curve is an envelop curve of all possible
plant sizes.

Also known as planning curve.

It envelops an infinite number of short run

average cost curves

It traces the lowest average cost of producing

each level of output.

Any point on the SAC curve that is tangential to

the LRAC is the lowest possible cost of producing
the output.
 Consider a single firm planning a
construction of a single plant
The firm has 3 alternative sizes to choose on
planning horizon
Each plant size generates its own SACC.
Which is the optimal size depends on the
anticipated rate of output per unit of time.
In the figure there are 3 SACs for three
respectively plant sizes.
 If plant size 1 is built AC will be C1.
Likewise for plant 2 AC will be C2 which is greater than C1.
So if anticipated rate of output is Q1 the appropriate plant
size is one from which SAC1 is derived. Hence AC = C2
If anticipated rate of output goes from Q1 to Q2 and if plant
1 is decided then???????????
AC will be C4
But if plant 2 is decided at Q2 then AC will be???????????
C3 which is clearly less than C4
This would be thus more profitable since unit costs falls.
C SAC1
SAC2
SAC3
C2
C4
C1
C3

0 Q1 Q
Q2
 Thus the entrepreneur is faced with infinite number
of choices of plant size.
By drawing the envelope of these various SAC, LAC
is derived.
Thus LAC shows the cheapest way to produce
various levels of output by changing plant size
LTC STC but never greater than STC
LAC SAC but never greater than SAC
 Why LAC is of U-shaped
SAC is U-shaped because of the law of diminishing
marginal returns in short run.
But in long run all factors are variable so there cant
be diminishing marginal returns.
It is U-shaped because of changing scale of
operations.
Economies of Scale (decreasing returns to scale)- any
decreases in LRAC that come about when a firm alters
all of its factors of production in order to increase its
scale of output
Diseconomies of Scale (increasing returns to scale)- any
increases in LRAC that come about when a firm alters
all of its factors of production in order to increase its
scale of output
Constant returns to scale LAC do not change with
changes in output
 Shape of LRATC

RS
4.00
3.00
LAC
2.00
1.00

0 130 184

Economies of Scale Constant Diseconomies of Scale

Returns to
Scale
Units of Output
 ECONOMIES OF SCALE
Specialisation as the firm grows managers can
concentrate on areas that they specialise in e.g. finance,
marketing etc and become more efficient
Division of Labour breaking the production process
down into small jobs and sometimes replacing people with
machinery
Bulk buying getting discount for buying larger supplies
Financial economies getting a better rate of interest on
loans because the company is less of a risk
Transport economies have their own transport fleet
Large machines when a firm is small they may not be
able to afford large machinery and may have to hire it but
as they grow they can buy it
Promotional economies such costs do not tend to
increase in the same proportion as output the cost of
promotion per unit of output falls
 DISECONOMIES OF SCALE
Control and communication problems as firms
grow the management will find it harder to control and
coordinate the activities of the firm. This may lead to
inefficiency and increases in unit costs of production
Alienation and loss of identity as firms grow
workers and managers may begin to feel that they are
only a very small part of the organisation
They may be less motivated and therefore work less
hard and become less productive
All of these economies and diseconomies of scale relate
to the unit cost decreases or increases that may be
encountered by a single firm they are internal
economies and diseconomies of scale
When the whole industry size increases and it effects
the unit costs these are known as external economies
and diseconomies of scale
 When economies of scale are exhausted,
constant returns to scale begin.
This is also called as commencement of
MINIMUM EFFICIENT SCALE (MES)
MES shows lowest rate of output at which LAC
are minimised & no further economies of scale
can be achieved in present time period.
Many manufacturing products experience
economies of scale since the firm in industry is
big.
While for construction industry benefits from
economies of scale are less
 LAC1 represents that of manufacturing unit
LAC2 represents that of construction unit
On LAC1 manufacturing firm is able to exploit economies of
scale. Thus MES is at Q2
Whereas LAC2 denotes projects with lower levels of
standardization experienced by construction firms
On LAC2 firm can achieve economies of scale at Q1

LAC2
AC LAC1

0 Q1 Q2 Output Q
 It would be beneficial to reorganise production
to be on LAC1
This could be possible through mergers and
acquisitions.
But in construction industry generally the
economies of scale has limited role.
In fact construction firms are actually on a long
run increasing cost curve.
Further economies of scale are divided into
External relates to whole industry. Eg work of govt
related to infra
Internal relates growth of a single firm in industry.
Producing standardised and prefabricated products
 LAC & LMC
Long-run Average Cost (LAC) curve
is U-shaped.
the envelope of all the short-run average cost
curves;
driven by economies and diseconomies of size.

Long-run Marginal Cost (LMC) curve

Also U-shaped;
intersects LAC at LACs minimum point.
 LAC & LMC

LMC
COST
SMC2 LAC

SAC2
SMC1 SAC1

0 Q1 Q