Chapter - 3
Theory of Production and Cost
Unit -2 Theory of Cost
◼ Cost Analysis
Cost analysis is related with the financial aspects of production
◼ Cost Concepts
1. Accounting Costs & Economic Costs
➢ Accounting costs (similar as Explicit cost or Outlay cost) are expenses which will have to be incurred
by firm and are recorded in books of accounts (financial statements).
➢ Economic Cost = Explicit cost + Implicit Cost
➢ Implicit Cost is cost of using self owned factors. E.g.- normal return on capital invested by owner
himself in his business; etc.
➢ Implicit cost includes normal profit
2. Outlay costs and Opportunity costs
➢ Outlay costs are actual expenditure.
➢ Opportunity cost is the cost of next best alternative opportunity which was foregone. It is cost of the
missed opportunity.
➢ Implicit cost is a type of opposite cost.
Total Revenue
(–) Explicit Cost ( accounting cost )
Accounting Profit
(–) Implicit Cost
Economic Profit
3. Traceable (Direct) costs and Non-Traceable (Indirect) costs
➢ Direct costs are costs that are readily identified and are traceable to a particular product, operation
or plant.
➢ Indirect costs are those which are not easily and definitely identifiable in relation to a plant, product,
process or department. E.g.- Electricity expenses, common or general expenses etc.
4. Incremental costs and Sunk costs
➢ Incremental cost refers to the additional cost incurred by a firm as result of a business decision.
(Marginal Cost)
➢ Sunk Costs are costs which are already incurred once and for all and cannot be recovered. They are
based on past commitments and cannot be revised or reversed if the firm wishes to do so. Like cost
incurred in advertising , R&D exp,
5. Historical costs and Replacement costs
➢ Historical cost refers to the cost incurred in the past on the acquisition of a productive asset such as
machinery etc.
➢ Replacement cost is the money expenditure that has to be incurred for replacing an old asset.
1 Theory of Production and Cost
, 6. Private costs and Social costs
➢ Private costs are costs actually incurred or provided for by firms and are either explicit or implicit.
➢ Social cost refers to the total cost borne by the society on account of a business activity and includes
private cost and External Cost.
7. Fixed Costs and Variable costs
➢ Fixed or constant costs are costs which do not vary with output up to a certain level of activity.
➢ These require fixed expenditure of funds irrespective of level of output e.g., rent, property taxes,
interest on loans etc.
➢ These require fixed expenditure of funds irrespective of level of output e.g., rent, property taxes,
interest on loans etc.
➢ Fixed cost is a function of capacity.
➢ If the firm closes down for some time in the short run but remains in business, fixed cost CANNOT
be avoided. (this cost is inescapable)
➢ Shut down costs are costs which will continue even after operations are suspended. E.g.- for storing
of old machines which cannot be sold in market.
➢ Variable Costs are costs which change with the level of output (it is a function of output)
➢ If a firm shuts down for a short period, then variable cost can be avoided like wages of labour, prices
of raw material, etc
8. Semi - Variable Cost
➢ Some costs which are neither perfectly variable, nor absolutely fixed in relation to the changes in
the size of output.
➢ E.g.: Electricity exp, Post-paid Phone Bill etc.
9. Stair-Step Variable Cost
➢ Some costs which may increase in a stair-step fashion, i.e., they remain fixed over certain range of
output: but suddenly jump to new higher level when output goes beyond a given limit.
2 Theory of Production and Cost
Theory of Production and Cost
Unit -2 Theory of Cost
◼ Cost Analysis
Cost analysis is related with the financial aspects of production
◼ Cost Concepts
1. Accounting Costs & Economic Costs
➢ Accounting costs (similar as Explicit cost or Outlay cost) are expenses which will have to be incurred
by firm and are recorded in books of accounts (financial statements).
➢ Economic Cost = Explicit cost + Implicit Cost
➢ Implicit Cost is cost of using self owned factors. E.g.- normal return on capital invested by owner
himself in his business; etc.
➢ Implicit cost includes normal profit
2. Outlay costs and Opportunity costs
➢ Outlay costs are actual expenditure.
➢ Opportunity cost is the cost of next best alternative opportunity which was foregone. It is cost of the
missed opportunity.
➢ Implicit cost is a type of opposite cost.
Total Revenue
(–) Explicit Cost ( accounting cost )
Accounting Profit
(–) Implicit Cost
Economic Profit
3. Traceable (Direct) costs and Non-Traceable (Indirect) costs
➢ Direct costs are costs that are readily identified and are traceable to a particular product, operation
or plant.
➢ Indirect costs are those which are not easily and definitely identifiable in relation to a plant, product,
process or department. E.g.- Electricity expenses, common or general expenses etc.
4. Incremental costs and Sunk costs
➢ Incremental cost refers to the additional cost incurred by a firm as result of a business decision.
(Marginal Cost)
➢ Sunk Costs are costs which are already incurred once and for all and cannot be recovered. They are
based on past commitments and cannot be revised or reversed if the firm wishes to do so. Like cost
incurred in advertising , R&D exp,
5. Historical costs and Replacement costs
➢ Historical cost refers to the cost incurred in the past on the acquisition of a productive asset such as
machinery etc.
➢ Replacement cost is the money expenditure that has to be incurred for replacing an old asset.
1 Theory of Production and Cost
, 6. Private costs and Social costs
➢ Private costs are costs actually incurred or provided for by firms and are either explicit or implicit.
➢ Social cost refers to the total cost borne by the society on account of a business activity and includes
private cost and External Cost.
7. Fixed Costs and Variable costs
➢ Fixed or constant costs are costs which do not vary with output up to a certain level of activity.
➢ These require fixed expenditure of funds irrespective of level of output e.g., rent, property taxes,
interest on loans etc.
➢ These require fixed expenditure of funds irrespective of level of output e.g., rent, property taxes,
interest on loans etc.
➢ Fixed cost is a function of capacity.
➢ If the firm closes down for some time in the short run but remains in business, fixed cost CANNOT
be avoided. (this cost is inescapable)
➢ Shut down costs are costs which will continue even after operations are suspended. E.g.- for storing
of old machines which cannot be sold in market.
➢ Variable Costs are costs which change with the level of output (it is a function of output)
➢ If a firm shuts down for a short period, then variable cost can be avoided like wages of labour, prices
of raw material, etc
8. Semi - Variable Cost
➢ Some costs which are neither perfectly variable, nor absolutely fixed in relation to the changes in
the size of output.
➢ E.g.: Electricity exp, Post-paid Phone Bill etc.
9. Stair-Step Variable Cost
➢ Some costs which may increase in a stair-step fashion, i.e., they remain fixed over certain range of
output: but suddenly jump to new higher level when output goes beyond a given limit.
2 Theory of Production and Cost
