What is Cost Analysis?

The entire idea of cost of production or definition of production cost is applied corresponding or we can say that it is related to investment or money cost. Money cost or investment refers to any money expenditure which the firm or supplier or producer undertakes in purchasing or hiring factor of production or factor services. 

Let us understand this with the help of an example:

For producing any commodity, the decision of production of the firm requires various factors of production like land labour, capital etc. Therefore, in order to employ all these factors of production, the producer needs to bear some cost or investment. For hiring labour, he/she needs to pay wages, for getting the land to set up a plant he/she needs to pay rent. Therefore, all these costs come under investment or money costs. All these money costs or investment are included in the accounting books of a firm as costs of production.

Money costs or investment made by the firms to the owners of various factor services (i.e. the household) in hiring and purchasing them as per what is required in the production process of goods, it is known as explicit cost. 

Although we should always keep in mind that, money expenditure or investment only constitutes a part of the cost. There are certain factor services which are owned by the entrepreneur himself for which no investment or money payment is made. Since no payment is made for such factor services, they are not included in the cost of production in the normal accounting practice. 

Economic Costs

Economists take cost of production in a wider sense, i.e., in the sense of economic cost. Economic cost consists of three components. 

They are:

• Money Cost or Explicit Cost or specifically investment
• Implicit Cost
• Normal Cost

Implicit Cost: Implicit Cost refers to the estimated value of inputs owned by the firm and used by it in its own production unit. Besides, purchasing or hiring resources from others, a producer may also use his/her own factor services in the process of production. The owner or the entrepreneur may own certain factor services which he/she may use in his/her own business. For example, the entrepreneur may use his/her own land, or his/her own capital and may provide entrepreneurial and managerial services. As such he/she is entitled to receive rent on his/her land, interest on the capital contributed by him/her and payment for such services. Thus, in case of such factors of production that the firm neither purchases nor hires, the cost must also be calculated. Such costs need to be imputed from what they could earn in their best alternative use. Such cost is known as implicit cost. 

Normal Profit: Normal profit is regarded the minimum payment which a producer must get in order to induce him to undertake the risk of production. Normal profit is the minimum supply price of the entrepreneurial services. It is, in a way, reward or remuneration for the services of the entrepreneurs. It is part of the cost of production because entrepreneurs expect to get it in the long run, he/she is not likely to undertake production. From an economic perspective, normal profit is also cost. 

Economic cost is now can be defined as the sum total of both explicit and implicit cost, including normal profit. 

Opportunity Cost

The opportunity cost of producing any good is the next best alternative good that is given up to produce this good. The cost of producing a quantity of a commodity is measured in terms of quantity of some other commodity that could have been obtained instead. The concept of opportunity cost arises because of the problem of scarcity resources and also because of the fact that these resources have alternative uses. 

Let us understand this with the help of an example:

In an economy, with the available resources, it is possible to produce cloth and bread. If a given amount of resources can produce 1 metre of bread or 20 loaves of bread. Then the cost of 1 metre of cloth is 20 loaves of bread which needs to be sacrificed in order to produce 1 metre of cloth.

[Note; It is important to know that opportunity cost of producing a good is not any other alternative that could be produced with the same amount of resources rather it is the next best alternative good that could be produced with the same resources.]

If with the given resources it is possible to produce cloth, bread or pencil but bread is the next best alternative good to cloth, then opportunity cost of producing cloth is expressed in terms of the amount of bread which is given up to produce cloth, and not in terms of pencil to be given up to produce it. 

Real Cost

Real cost advocates the notion to the efforts and sacrifices made by the owners of factors of production used in the production of commodity. Labor has to put physical and mental efforts in doing a work. Owners of capital and land to make sacrifices by not using these resources themselves or in terms of sacrifice involved in saving and capital accumulation. Thus, real cost refers to the pain, sacrifice, discomfort and disutility involved in providing factor services required to produce a commodity.

Private and Social Cost

Private cost refers to the cost of production incurred or beard by an individual firm in producing a commodity. In other words, we can say that private cost is as same as economic cost and also includes both implicit and explicit cost. 

On the other hand, social cost refers to the cost that the society has to incur on account of the production of a commodity. It is the sum total of the cost incurred by the producers of goods and services and the cost experienced by those who have to suffer because of the production of the commodity in terms of external cost.

Now the question comes, that what is external cost?

External cost is that cost which is not incurred by the firm, but is incurred or undertaken by other members of the society or the entire society.

Let us understand this with the help of an example:

Oil refinery may discharge its waste in the river causing water pollution. Those who are living near the water bodies, they need to undertake the responsibility as well as the expenditure to clean the waterbody. Similarly take the example, buses and trucks causing air pollution and noise pollution. Such air, water and noise pollution cause health hazards and thereby involve cost to the entire society. These costs are not taken into account by the individual producers and therefore, are not a part of private costs. But these should be taken into account of cost of production.

 The definition of various kinds of costs are given below. The analysis of these costs is important in order to measure the risk and outcome. It also helps to determine that what kind of output in terms of production is actually necessary. It helps to estimate that what kind of cost benefit analysis or benefit or CBA can be achieved through such a result. The producer or the business owner also calculate the revenue which does involve the total benefit and the risk that is being undertaken. 

Behavior of Cost in the Short Run

Fixed Cost and Variable Cost:

Corresponding to fixed factors (factors of which the quantity cannot be changed in a short run) and variable factors (factors of which the quantity can be changed in a short run), economic cost is classified into two categories: (i) Fixed Cost- The cost which is incurred on fixed factors. It consists of salary of the permanent staff, interest on the borrowed capital, depreciation of machinery, etc. (ii) Variable costs- The cost which is incurred on variable factors. It consists of expenditure incurred on raw materials, wages and salaries paid to casual workers, etc. 

Total Cost Curves

Total obligations incurred by the firm in producing any given quantity of output, is known as total cost curves (TC). It is the sum total of all expenses incurred in producing a certain volume of output. For example: If total investment or money expense in producing 100 pens is Rs.1000/-, then the total cost of producing 100 pens is Rs.1000/-. Now total cost can be divided into two parts: Total Fixed Cost and Total Variable Cost.

• Total Fixed Cost (TFC)

Total Fixed Cost refers to the total cost incurred by the firm on the use of all fixed factors.  This cost is independent of output, i.e., it does not change with change in the quantity of output. It remains constant irrespective of the quantity of output produced. Even if the firm produces one unit of commodity, the fixed cost has to be incurred by the firm. For example: A shopkeeper has to pay rent for the shop np matter what is the output or sale during a month. That is why this cost is also known as unavoidable cost. 

• Total Variable Cost (TVC)

Total variable cost refers to the total cost incurred by a firm on the use of the variable factors. This includes payments for raw materials, wages paid to temporary and casual labours, payment for fuel and power used in production. This cost is dependent of output, i.e., it does change with change in the quantity of output. It changes along with the quantity of output produced. For example: If firms want to produce more shirts, they have to buy rawer materials like yarn and hire more workers. Since these costs change with the change in the volume of output, they are called variable costs. Variable cost is also known as avoidable cost. 

• Total Cost (TC)

Total Cost is the cost incurred on all types of inputs- fixed as well as variable inputs- incurred in producing a given amount of input. The cost of fixed factors is total fixed cost and that of variable factors is called total variable costs. 

      TC = TFC+TFC

Table: 1

TFC Curve

As table 1 shows, total fixed cost remains constant at Rs. 130 for the entire range of output, i.e., from 0 to 6 units. It does not change with a change in output. Even if no output is produced, the firm has to bear the fixed cost because it cannot throw out fixed factors in the short run and they will remain idle till the firm decides to produce. 

TVC Curve

As table 1 shows, total variable cost changes with changes in output. If would be seen from the table that total variable cost increases with output. But the rate of increase is different at different levels of output. The TVC curve is concave downward up to OQ level of output indicating that the variable costs increase at a decreasing rate, and subsequently it is concave upward indicating that variable costs increasing at an increasing rate. 

TC Curve

Total cost is the sum total of total fixed cost and total variable cost. It varies directly with output because of increase in output. TC in the figure 1 is obtained by adding up vertically TFC curve and TVC Curve because the total cost is the sum total of total fixed cost and total variable cost at every level of output. 

Average Cost Curves

Average cost curve is nothing but the total cost divided by the number of units of goods produced. With respect to three types of total costs in short-run, there are three types of average costs. 

• Average Fixed Cost (AFC): Average Fixed cost is the per unit cost of fixed factors. It is obtained by dividing total fixed costs with the total units of output produced.   AFC is TFC divided by Q, where Q represents number of outputs. AFC curve slopes downward throughout its length from left to right showing continuous fall in AFC with an increase in output.

• Average Variable Cost (AVC): Average Variable Cost is the per unit cost of variable factors of production. It is obtained by dividing total variable cost with the units of output. AVC=TVC/Q. For a better understanding refer to table.2. The behaviour of AVC curve is shown in figure.2. The AVC curve slopes downward up to output OQ2 showing decrease in the average variable cost, and slopes upward beyond output OQ2 indicating an increase in the average variable cost, in other words, AVC curve is U-shaped. 

• Average Cost (AC) or Average total cost (ATC):  Average total Cost is the per unit cost of both variable and fixed factors of production. It is obtained by dividing total cost with the units of output. AC curve can be obtained by adding the AFC and AVC curves. ATC is the vertical summation of AFC and AVC curves. Therefore, at each level of output, ATC curve lies above AVC equal to the value of AFC curve. 

Table: 2

Marginal Cost (MC)

Marginal cost is the additional to total cost as one or more unit of output is produced. In other words, marginal cost is the additional to total cost of producing n units instead of n-1 units (where n is a given number).Marginal cost is the additional to total cost as one or more unit of output is produced. In other words, marginal cost is the additional to total cost of producing n units instead of n-1 units (where n is a given number). $M{C}_{n=}T{C}_n–T{C}_{n-1}$

For example: Marginal Cost of 4^th unit is the change in total cost when the output is increased from 3 units to 4 units.  Marginal Cost is computed by taking the difference between successive total costs of corresponding to the different levels of output.  Diagrammatically, MC for any level of output can be calculated by taking the slope of the total cost curve corresponding to that level of output. 

The U- Shape of MC curve is because of the law of variable proportions. It is negatively sloped in the initial stage of production due to increasing returns to the variable factor and is positively sloped thereafter due to decreasing returns to variable factor.

Cost analysis of a production is extremely important in order to maximise profit or benefit and minimise cost for a producer so that the business can perform well in the long run and also sustain in the market along with its competitors. The concept of total cost average cost and marginal cost forms the foundation of the cost analysis. Therefore, these concepts are important in order to analyse that how the production process should be carried out so that the marginal cost is less than the average cost and also the revenue should be calculated so that the producer do not run-in losses but rather gains from the production of the goods and services in the business. 

Therefore, in the conclusion it can be said that the entire cost analysis is done based on the Benefit and cost benefit analysis which is popularly known as CBA or benefit-cost analysis that is calculated by taking the benefit-cost ratio. the method to determine that what kind of decision is to be taken, it is important two calculate the net present value of the current investment and what will be the future value of the investment that has been undertaken. The result or the outcome that has been done after taking into consideration the measure of the benefit or total benefits, the decision of the investment is proposed. To evaluate the analysis of cost, the present value and NPV, the discount rate and the cash flows are also taken into consideration which comes under financial analysis. It is important for the decision-makers while decision- making to analyze the economic value of the investment along with the net benefits which is usually data driven. The main motive of the businessman always remains to do the investment in such a way that is cost effective. They are for the analysis of course while taking into consideration the production process is very crucial.

The cost-benefit is related to the monetary value of the investment. The stakeholder also plays an important role in the entire process of project management which is the part of cost analysis as well. When it comes to the project management part of the production process, comparison between various kinds of investment is taken into consideration which includes that what payback. Is required and how the evaluation should be done. All step-by-step analysis can only be done in terms of the financial analysis. 

Context and Applications   

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for 

• B.B.A   
• MBA