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OMBC 104:
MANAGERIAL ECONOMICS

Unit 5: COST ANALYSIS

By

Prof. Dattatray katore

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 Actual cost
• Actual cost is the cost paid by the firm for labor,
material, plant, building, machinery, equipment, and
transport etc.
• All these payments are recorded in the account books
of the firm.
• This concept comes under the accounting cost.

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 Opportunity cost

• The opportunity cost is related to scarcity

concept.
• The opportunity cost of an item is what you give
up to get that item.
• opportunity cost of an item refers to all those
things that must be forgone to acquire that item.

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 Opportunity cost

• A bakery is planning to invest Rs 20 000 in a new

machine which will increase its production of
croissants by 10 per cent. The financial director
of the company points out that account needs to
be taken of what that Rs. 20 000 could earn if
invested in another way, such as in an interest-
bearing account at a bank, as part of the cost
calculations. Why do you think she insisted that
this was taken into consideration and why is it
classed as a cost.

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 Opportunity cost

• When Rahul pays Rs. 1000 for a stock of flour, he

can no longer use that Rs.1000 to buy something
else; he has to sacrifice what else that Rs.1000
could have purchased. Similarly, when Rahul
hires workers to make the pizzas, the wages he
pays are part of the firm’s costs.

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 Explicit vs Implicit

• costs require the firm to pay out some money,

they are called explicit costs. By contrast, some
of a firm’s opportunity costs, called implicit
costs, do not require a cash outlay.

• For every hour that Rahul works at his pizza

factory, he gives up Rs.100 in income, and this
forgone income is also classed as part of his
costs by an economist

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 Private and social cost

• if a firm expands its output it will lead

to increase in the costs of the firm
these will be known as private cost .
• But this will also lead to certain costs
to society in the form of greater
pollution, greater congestion
• These costs are external to the firm.

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 Short-Run Costs

• The firm can vary its output by varying only the amount of
variable factors such as labor and raw material.
• fixed factors such as capital equipment, machinery, plant,
management personals cannot be varied.
• Output can only be increased by overworking the existing
plant or using the plant intensively and by hiring more
workers and buying more raw materials.
• When there is zero output total variable cost is Zero,
increases with increase in output.
• but the firm has to bear fixed cost even if it produces zero
output.
 Short-Run Costs

• Fixed Cost: in the short run firm requires to incur few fixed
costs initially in short period irrespective of the level of
output.
• Variable Cost- the variable cost is the one which keeps
changing with the changes in the level of output.
• Total Cost = Total Fixed Cost (TFC) + Total Variable Cost
(TVC).
 Fixed cost vs. Variable cost
• Fixed costs are known as supplementary costs and
indirect costs. These costs are on volume for certain
given output. Fixed costs are not variable with a certain
level of output. Fixed costs are
a) Managerial and administrative staff.
b) Depreciation of machinery, building and other fixed
assets.
c) Costs on plant, building, land etc. And other fittings.
• These costs are fixed for a short period. These costs
have to be incurred even if the plant is closed for a
short period.

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 Fixed cost vs. Variable cost
• Variable costs are also known as prime costs, and direct
costs. These costs vary with production, so it is the
function of output.
• Variable costs are:
a) Cost of Raw materials.
b) Direct labor costs.
c) Running cost of fixed capital assets such as fuel, oil,
lubricants, repairs, maintenance expenditure and all other
input costs.
d) Taxes, indirect taxes such as excise duties, sales tax,
value added tax, octroi duty etc.

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Fixed cost vs. Variable cost

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 Total, Average and Marginal costs
• Variable costs are also known as prime costs, and direct
costs. These costs vary with production, so it is the
function of output.
• Variable costs are:
a) Cost of Raw materials.
b) Direct labor costs.
c) Running cost of fixed capital assets such as fuel, oil,
lubricants, repairs, maintenance expenditure and all other
input costs.
d) Taxes, indirect taxes such as excise duties, sales tax,
value added tax, octroi duty etc.

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 Short-Run Average cost concepts
• (i) Average fixed cost (AFC);
• (ii) Average variable cost (AVC) and
• (iii) Average total cost (ATC).

• AFC =

• AVC =

• MCn = TCn – TCn-1

• MC =
Fixed cost vs. Variable cost

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 Cost behavior
• AFC decreases with increase in output cont. but does not
even touch X-axis
• AVC decreases initially due to economies of scale and
starts rising due to dis-economies of large scale of
production.
• AC=AVC+AFC
• Initially AC is high due to large fixed cost and small output
• As output increases the FIXED cost goes on decreasing
because it is now shared by larger quantity of output.
• caused due to Internal economy and fuller use of
indivisible factors. Later on AC goes on rising due to dis-
economies of scale and it gives the curve U shape. So AC
curve are always U shaped.
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 Cost behavior
• Relation between AC and MC
• Optimum output
• Profit maximizing output

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 Long Run Cost Output Relation
• Firm has three options depending upon the market size, demand situations
• . If demand is small, the firm will use 1, it will have to incur higher cost average
cost.
• For OQ2 level of output, it has two options: (i) plant 1. (ii) plant 2.
• SAC of plant 2 is lower than the SAC of plant 1 due to economies of scale
• Due to economies of scale is per unit cost of production is low
• Plant C is larger size than plant 2, but the SAC3 is higher than SAC2 curve, because
of diseconomies of scale

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 Long Run Cost Output Relation
• The long run period is long enough to enable the firm to
vary all its inputs i.e. plant, machinery, equipment
building and space.
• The firm is not tied to a particular plant capacity.
• In response to growing demand firm may start new plants
or expand existing.
• In the long run all costs are variable and no cost is fixed.

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Long Run Cost Output Relation

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Long Run Cost Output Relation

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Long Run Cost Output Relation

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Long Run Cost Output Relation

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 Economies of scale.
• The term economies of scale denotes saving in cost of
production with an increase in the scale of output or the size of
the plant.
• It does not mean a reduction in total cost in absolute terms.
• It only means a reduction in relative terms and manifests itself in
a reduction in average cost of output
• The scale of production has important bearing on the cost of
production.
• Larger the scale of production lower is the average cost of
production.
• This low cost is the result of economies of scale.
• These economies are classified as internal and external
economies.
A) Internal economies and
B) External economies
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 Economies of scale.

• Internal economies and diseconomies of scale

are those economies which occur due to
endogenous (or internal) causes.

• External economies and diseconomies of scale

are the result of some exogenous or external
causes which are not directly connected with the
activities of the firm.

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 Internal Economies of scale.
• Internal economies are available to an individual firm
which is related to production and only the firm is
benefited when it expands its output or enlarges its scale
of production.
• They can be
• a) Technical Economies-the choice of inputs and
their varieties becomes wider for the firm
• b) Managerial Economies- Same Managers
with same cost to firm manage larger plant with
larger output
• c) Commercial Economies of Scale
• d) Financial Economies.- creditworthiness,
bargaining power of bigger firm
• e) Risk bearing Economies- diversification
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 Technical Economies
• High capacity- Larger machines due to higher capacities
reduce the operating cost
• Backward and forward linkages- a dairy having its own
feeder farm, a sugar mill may start producing ethanol,
paper making or alcohol unit.
• Superior technique- advanced technology- Increased
specialization and division of labour.

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 Managerial Economies
• A large scale unit can manage a big unit by adopting the
policy of delegation of power, grouping of establishments
on a scientific way.
• The company hires the services of professionals and
experts. But the small unit can be managed by a manager
hence it does not have the benefit of reducing the cost.

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 Commercial Economies
• Dominance in placing tenders and bids
• Bargaining power in buying in bulk raw materials and
other supplies.
• Freight concessions, Cheap credit from banks, Prompt
delivery, careful attention.
• Tata motors enjoy a 365 days credit to make payments to
their vendors.
• Proper treatment of customers, Research and
development that leads to innovation and inventions
Material testing.
• Can raise capital easily at cheaper cost.

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 Financial Economies.
• Large scale unit enjoys financial facilities in the form of
letter of credit. Terms of credit, discounting of commercial
papers etc. from the financial institutions.
• Can raise capital easily at cheaper cost.

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 Risk bearing Economies
• Risk is spread over and it can be eliminated. It can
diversify source of raw material, diversify market and
process of manufacturing.

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 B) External economies
• the situation when the gains are accruing to all the firms
in an industry due to growth of the industry.
• such as availability of new and cheaper source of raw
material, tools, machinery, discoveries, diffusion of
superior technical knowledge and trade journals etc.
• Pune city is automobile hub, many OEM automobile
companies are located pune and many are willing to start
due large number of ancillaries developed.

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 B) External economies
• the situation when the gains are accruing to all the firms
in an industry due to growth of the industry.
• such as availability of new and cheaper source of raw
material, tools, machinery, discoveries, diffusion of
superior technical knowledge and trade journals etc.
• Pune city is automobile hub, many OEM automobile
companies are located pune and many are willing to start
due large number of ancillaries developed.

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 Economies of Localization
• Here skilled labor, better transport, credit facilities,
benefits from subsidies, common stock of knowledge, and
stimulation of improvements are available to all units.

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 Economies of Information
• A large growing industry can bring out trade and technical
journals. These are accessible to every firm. Many
associations come up and encourage research,
disseminate technical knowledge to the other firms. It
also enlightens the industry about fiscal policy of the
government etc.

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 Economies of Disintegration
• Some of the jobs can be given to some other efficient
subsidiary industry. Paper and pulp manufacturing units
are bifurcated. The paper manufacturing units are near
the market and the pulp manufacturing unit is established
in the remote areas near the raw material.
• Economies of Bye Product A large industry can make use
of waste material for manufacturing bye products. For
example sugar industry can use sugar cane juice for
making sugar and it has waste like bag gasses, and
molasses which the industry can convert in to paper,
cardboard and molasses can be used for manufacturing
industrial alcohol.

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 Dis-economies of Scale
• Dis-economies of scale can be classified into
• a) Internal dis-economies of scale which may be in the
form of managerial inefficiency, labour inefficiency,
difficulty in decision making, increased risk, etc
• Limits of Entrepreneurship, Managerial Autonomy
• b) External dis-economies of scale may be in the form of
scarcity of supply of factors of production, possibility of
depression, cut throat competition, dependence on
foreign market, lack of adaptability, etc.

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Break Even analysis

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Break Even analysis

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Break Even analysis

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THANK YOU
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