What is Cost?

Cost refers to the total expenditure made on inputs or resources that are used for the production of final goods or services. The resources used by a firm are limited in nature and thus require efficient allocation to maximise the firm’s profit. The cost or economic cost of a firm consists of all the expenses it faces, can manage, and are beyond its control. For example, cost of labor, capital, and raw materials. Besides other resources, a firm may also use those resources whose expenses are not that clear but are still essential for the firm. The cost concept is also used in cost accounting.

The cost is the sum of the Explicit Cost and Implicit Cost.

• Explicit Cost: The actual expenditure made on the inputs or the payments made to the outsiders to hire their factor services is known as Explicit Cost. For example, wages paid to the workers, payment for land, payment for raw materials, etc.
• Implicit Cost: The estimated value of the inputs supplied by the owners along with the normal profits is known as Implicit Cost. For example, estimated rent on own land, imputed salary for the entrepreneur’s services, etc.

Types of Cost

There are different types of economic costs such as Total Costs, Opportunity Costs, Sunk Costs, Average Costs, Marginal Costs, Fixed Costs, and Variable Costs.

1. Total Cost

In the short run, some of the factors are fixed, while other factors are variable. In the same way, the short-run costs are also categorised into two different kinds of cost; viz., Fixed Costs and Variable Costs. The sum total of these costs is equal to the Total Cost.

I. Total Fixed Cost (TFC) or Fixed Cost (FC):

The costs on which the output level does not have a direct impact are known as Fixed Costs. For example, salary of staff, rent on office premises, interest on loans, etc. Other names of fixed costs are Supplementary Cost, Overhead Cost, Unavoidable Cost, Indirect Cost, or General Cost. Fixed cost is the cost spent on fixed factors such as land, building, machinery, etc. The amount spent on these factors cannot be changed in the short run. Also, the payment made on these factors remains the same whether the output is small, large, or zero.

II. Total Variable Cost (TVC) or Variable Cost (VC):

The costs on which the output level has a direct impact are known as Variable Costs. For example, fuel, power, payment for raw materials, etc. Other names of variable costs are Prime Cost, Avoidable Cost, or Direct Cost. In other words, variable cost is the cost spent on variable factors such as power, direct labour, raw material, etc. The amount spent on these factors changes with the change in output level. Also, these costs arise till there is production and become zero at zero output level.

III. Total Cost (TC):

The total expenditure incurred by an organisation on the factors of production which are required for the production of a commodity is known as Total Cost. In simple terms, total cost is the sum of total fixed cost and total variable cost at different output levels.

TC = TFC + TVC

As the Total Fixed Cost remains the same at all output levels, the change in Total Cost completely depends upon Total Variable Cost.

2. Average Cost

Average Costs are the per unit costs which explain the relationship between the cost and output in a realistic manner. These per-unit costs are obtained from Total Fixed Cost, Total Variable Cost, and Total Cost. The three different types of per-unit costs are as follows:

I. Average Fixed Cost (AFC):

The per unit fixed cost of production is known as Average Fixed Cost. The formula for calculating Average Fixed Cost is:

[Tex]Average~Fixed~Cost~(AFC)=\frac{Total~Fixed~Cost~(TFC)}{Quantity~of~Output~(Q)} [/Tex]

With an increase in the output, Average Fixed Cost falls. It is because the total fixed cost remains the same at all output levels. 

AFC curve does not touches X-axis and Y-axis.

AFC is a rectangular hyperbola and hence approaches both the axes. The curve gets near to the axes, but never touches them. It means that AFC can neither touch X-axis (because TFC can never be zero) nor Y-axis (because TFC is positive at zero output level and if we divide any value by zero, it will be an infinite value).

II. Average Variable Cost (AVC):

The per unit variable cost of production is known as Average Variable Cost. The formula for calculating Average Variable Cost is:

[Tex]Average~Variable~Cost~(AVC)=\frac{Total~Variable~Cost~(TVC)}{Quantity~of~Output~(Q)} [/Tex]

Initially, Average Variable Cost falls with an increase in output. Once the output increases till the optimum level, the average variable cost starts to rise.

III. Average Total Cost (ATC) or Average Cost (AC):

The per unit total cost of production is known as Average Total Cost or Average Cost. The formula for calculating Average Total Cost is:

[Tex]Average~Cost~(AC)=\frac{Total~Cost~(TC)}{Quantity~of~Output~(Q)} [/Tex]

Another way to define Average Total Cost is by the sum of Average Fixed Cost and Average Variable Cost; i.e., AC = AFC + AVC. 

Just like Average Variable Cost, average cost also initially falls with an increase in output. Once the output increases till the optimum level, the average cost starts to rise.

3. Marginal Cost

The additional cost incurred to the total cost when one more unit of output is produced is known as Marginal Cost. For example, if the total cost of producing 2 units is ₹400 and the total cost of producing 3 units is ₹600, then the marginal cost will be 600 – 400 = ₹200.

MC_n = TC_n – TC_n-1

Where,

n = Number of units produced

MC_n = Marginal cost of the n^th unit

TC_n = Total cost of n units

TC_n-1 = Total cost of (n-1) units

Another way to calculate Marginal Cost:

When the change in the units produced is more than one unit, then the previous formula of calculating MC will not work. In that case, the formula for calculating Marginal Cost will be:

[Tex]MC=\frac{Change~in~Total~Cost}{Change~in~units~of~Output}=\frac{\Delta{TC}}{\Delta{Q}} [/Tex]

For example, if the total cost of producing 5 units is ₹700 and the total cost of producing 3 units is ₹250, then the marginal cost will be:

[Tex]MC=\frac{700-250}{5-3}=\frac{450}{2} [/Tex]

Marginal Cost = ₹225

Example:

For the following table, find out AVC and MC at each output level.

Solution:

* TFC = TC at 0 output

Difference between Marginal Cost, Average Cost, and Total Cost