Cost Types

  • Differentiate between fixed and variable costs and their relation with quantity manufactured.

  • Understand importance of incremental cost at any instance of production.

  • Define average cost.

  • Interpret sunk cost with examples.

Fixed Costs
Fixed Cost

Fixed costs are costs that must be paid whether or not any units are produced. These costs are "fixed" over a specified period of time or range of production. e.g. cost of land, building, machinery and permits.

Variable Costs
Variable Cost

Variable costs are costs that vary directly with the number of products produced. For instance, the cost of the materials needed and the labour used is directly proportional to the quantity manufactured.

  • In the next diagram, the fixed costs will always be represented by horizontal straight line (parallel to quantity axis) as it is independent of quantity.

  • The variable cost will always pass through the origin as no manufactured units means no variable cost.

Total Cost
Total Cost

Total cost is addition of fixed cost and variable cost. It will be represented by a line having same slope as that of variable cost. However, it will be ’lifted up’ by an amount equal to fixed cost. Which means the y-intercept of total cost line is always equal to fixed cost.

Average Costs

The Average Cost is the per unit cost of production obtained by dividing the total cost (TC) by the total output (Q). By per unit cost of production, we mean that all the fixed and variable cost is taken into the consideration for calculating the average cost. Thus, it is also called as Per Unit Total Cost. \[\begin{aligned} \mathrm{Average\ Cost} &= \dfrac{\mathrm{Total\ Cost}}{\mathrm{Quantity}}\\ AC &= \dfrac{TC}{Q}\end{aligned}\]

Incremental Costs

If a company decides to increase production, it will incur additional costs. Incremental cost is the total cost incurred or anticipated due to an additional unit of product being produced. Incremental cost is calculated by analyzing the additional expenses involved in the production process, such as raw materials, for one additional unit of production. A company can still be profitable even if incremental cost exceed incremental revenue, but its profit starts declining at that point. Additional units need not be manufactured if incremental cost is adverse in comparison to incremental revenue, unless there is a compelling reason to do so.

Sunk Costs

Sunk cost, in economics and finance, a cost that has already been incurred and that cannot be recovered. In economic decision making, sunk costs are treated as bygone and are not taken into consideration when deciding whether to continue an investment project.
In real life, money spent on baseball games, non-refundable airfare, or even tuition fees for getting a major you eventually did not find useful represent sunk costs because there is no way to recover them.

Solved Example:

16-1-01

Cost of land is treated as:

Solution:
Cost of land is a one-time cost, which does not depend upon the quantity of manufactured units. Hence it should be considered as fixed cost.

Correct Answer: A

Solved Example:

16-1-02

A variable cost in break-even analysis changes according to:

Solution:
The variation part of the variable cost comes from the quantity and not from time or location factor.

Correct Answer: B

Solved Example:

16-1-03

Match the cost concepts in List I and their description in List II

List I (Cost concepts)
P. Sunk cost
Q. Marginal cost
R. Investment cost
S. Implicit cost

List II (Description)
i. Change in total cost for a unit change in output
ii. Cost that exists without the exchange of cash
iii. Money that has already been spent and cannot be recovered.
iv. Cost of converting an opportunity into operation

(UGC Paper II: Commerce Oct 2020 Shift II)

Correct Answer: A