Theory and Analytics of Costs (B)
What is the definition of costs? What is the relation between average cost and marginal cost? What is the cost breakeven point?
Posted: Jan 2012
Definition of Costs
Production of finished goods is consuming the production factors, which have its own market price. Costs are defined as financial expression of consumed production factors. There are two types of costs:
Explicit ( accounting ) costs that relates to financial spending for factors consumed during production. These factors are salaries, rents, material, energy, ...
Implicit ( economic ) costs that are not related to financial spending, but represent consumption of own resources, e.g. merchant does not pay the rent, but is running the business in own premise.
Classification of Costs
Accounting is analytically tracking costs, based on cost types. Cost are divided into following groups:
Fixed Costs that do not change with change with scale of the business. Cost like rent, depreciation, salaries etc. Do not change with change of scale of business.
Variable Costs change with change in scale of business. Costs like material costs, utility costs, performance incentives grows as the business activity grow. Cost can change proportional, progressive or regressive versus production output.
Period Costs ( combination of fixed and variables costs ) occur within certain time cycles. Example, maintenance, upgrades, expansions of capacity, ...
Costs are also classified according their functional origin. Therefore, they can be related to production, procurement, marketing, R&D, administration, finance, ... Based on control function perspective, they can be standard and real costs.
Function of Costs: Total, Average and Marginal Cost
Total Cost is the sum of fixes and variable costs:
TC = FC + VC
Average Costs is calculated by dividing total cost by produced quantity:
AC = TC/q
Marginal Cost represents the additional cost of for every additional produced unit:
TCn - TCn-1 dTC
MC = ------------------------- = ------
qn – qn-1 dq
Average Variable Cost is the ratio of total variable costs and production
AVC = VC/q
Average Fixed Cost is the ratio of total fixed costs and production.
AFC = FC / q
The company will have the lowest average costs per produced unit with level of production where Marginal Cost is equal to Average Cost ( MC = AC ).
Relationship Between Cost Curves
M – Meeting point of Average Cost and Marginal Cost ( breakeven point ). This point represents lowest market price where the company can cover costs.
M1 – Meeting point of Average Variable Costs and Marginal Cost ( closing point ). It represents the lowest price level that can cover variable costs.
Elasticity of Costs
Costs Elasticity is ratio between cost change and production quantity change:
dTC / TC MC >
Etr = ------------------------ = --------- = 1
dq / q AC <
Etr > 1 Margin Cost is higher than Average Cost ( costs are growing faster than production )
Etr < 1 Margin Cost is lower than Average Cost ( zone of decrease of average costs )