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Ravi Kiran

Fixed cost: unaffected by changes in output Variable cost: vary in total with the quantity of output (or similar measure of activity) Direct: can be measured and allocated to a specific work activity Indirect: difficult to attribute or allocate to a specific output or work activity (also known as overhead costs)

If aircraft are to be made then a factory is required.

The land, the factory building, the machinery and office equipment must be bought or rented.
These costs are called fixed costs and must be paid even when the factory has not produced anything. Fixed costs are costs that do not change, whatever the level of output is. Assuming an airplane factory has fixed costs of Rs60 million.

T F C

60 TFC

O Units of output

Variable costs change as the level of output changes. These costs are costs such as raw materials in production, labour units, electricity charges etc. In our example this would be the steel, components and labour needed to make each airplane. If nothing were made the variable costs would of course be nothing. But as production rises the total variable costs (TVC) would rise.

The variable cost is the cost per unit. The total variable cost is found by multiplying the variable cost (VC) by the level of output (Q), so TVC = VC x Q.

TVC Increasing at an increasing rate T V C

Increasing at a diminishing rate

O TVC

Total costs are simply the sum of the total variable costs and the fixed costs. TC and TVC lines are parallel.

The distance between the two lines is the amount of the fixed costs.

Output
0

FC
60

TVC
0

TC
60

10
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60
60 60

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20 30

70
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40
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60
60

40
50

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TC

Y
T F C Increasing at an increasing rate TVC

60

Increasing at a diminishing rate TFC

O Units of output

Average costs are per unit costs Average fixed costs (AFC) are the fixed costs divided by the level of output (FC/Q). So when output is 10 the AFC is 60/10 = 6. Average variable costs (AVC) are the total Variable costs divided by the level of output (TC/Q). Average total costs (ATC) are the total costs divided by the level of output (TC/Q). So when output is 10 the average fixed cost is 70/10 = 7.

Marginal cost Marginal cost is the cost of producing one extra unit. Marginal cost = the change in total costs the change in output MC = TC Q

Historical Costs : These are the accounting costs carried in the books and reflecting the cost of the item at the time it was purchased, rather than its current value. Sunk cost: Irrecoverable cost. A cost that has occurred in the past and has no relevance to estimates of future costs and revenues related to an alternative course of action.

Opportunity cost: the monetary advantage foregone due to limited resources. The cost of the best rejected opportunity. Life-cycle cost: the summation of all costs related to a product, structure, system, or service during its life span. Life cycle begins with the identification of the economic need or want ( the requirement ) and ends with the retirement and disposal activities.

If there is no alternative use for a factor of production, as in the case of a machine designed to produce a specific product, and if it has no scrap value, the opportunity cost of using it is zero. In such a case, if the output from the machine is worth more than the cost of all the other inputs involved, the firm might as well use the machine rather than let it stand idle. What the firm paid for the machine its historic cost is irrelevant. Not using the machine will not bring that money back. It has been spent. These are sometimes referred to as sunk costs.

If you fall over and break your leg, there is little point in saying, If only I hadnt done that I could have gone on that skiing holiday; I could have taken part in that race; I could have done so many other things (sigh). Wishing things were different wont change history. You have to manage as well as you can with your broken leg. It is the same for a firm. Once it has purchased some inputs, it is no good then wishing it hadnt. It has to accept that it has now got them, and make the best decisions about what to do with them.

Take a simple example. The local greengrocer in early December decides to buy 100 Christmas trees for Rs 10 each. At the time of purchase, this represents an opportunity cost of Rs10 each, since the Rs10 could have been spent on something else. The greengrocer estimates that there is enough local demand to sell all 100 trees at Rs20 each, thereby making a reasonable profit.

But the estimate turns out to be wrong. On 23 December there are still 50 trees unsold. What should be done? At this stage the Rs10 that was paid for the trees is irrelevant. It is a historic cost. It cannot be recouped: the trees cannot be sold back to the wholesaler! In fact, the opportunity cost is now zero. It might even be negative if the greengrocer has to pay to dispose of any unsold trees. It might, therefore, be worth selling the trees at Rs10, Rs5 or even Rs 1. Last thing on Christmas Eve it might even be worth giving away any unsold trees.

Investment Cost or capital investment is the capital (money) required for most activities of the acquisition phase; Working Capital refers to the funds required for current assets needed for start-up and subsequent support of operation activities; Operation and Maintenance Cost includes many of the recurring annual expense items associated with the operation phase of the life cycle; Disposal Cost includes non-recurring costs of shutting down the operation;

Recurring costs are repetitive and occur when a firm produces similar goods and services on a continuing basis. Variable costs are recurring costs because they repeat with each unit of output . A fixed cost that is paid on a repeatable basis is also a recurring cost:

Office rental

Nonrecurring costs are those that are not repetitive, even though the total expenditure may be cumulative over a relatively short period of time; Typically involve developing or establishing a capability or capacity to operate; Examples are purchase cost for real estate upon which a plant will be built, and the construction costs of the plant itself;

Provide information used in setting a selling price for quoting, bidding, or evaluating contracts Determine whether a proposed product can be made and distributed at a profit (EG: price = cost + profit) Evaluate how much capital can be justified for process changes or other improvements Establish benchmarks for productivity improvement programs

Uses historical data from similar engineering projects Used to estimate costs, revenues, and other parameters for current project Modifies original data for changes in inflation / deflation, activity level, weight, energy consumption, size, etc

More detailed cost-estimating method Attempts to break down project into small, manageable units and estimate costs, etc. Smaller unit costs added together with other types of costs to obtain overall cost estimate Works best when detail concerning desired output defined and clarified