In This Article

  1. Introduction
  2. Types of Costs
  3. Short-Run Cost Curves
  4. Cost Relationships
  5. Break-Even Analysis
  6. Conclusion

Introduction

Understanding costs is fundamental to business decision-making. Costs determine profitability, pricing decisions, production levels, and strategic choices. Different cost concepts serve different purposes in managerial analysis.

Types of Costs

By Behavior

TypeDefinitionExamples
Fixed Costs (FC)Don't change with output levelRent, insurance, salaries
Variable Costs (VC)Change with output levelRaw materials, direct labor, utilities
Semi-VariableHave fixed and variable componentsPhone bills, electricity

By Traceability

  • Direct costs: Directly traceable to a product (raw materials)
  • Indirect costs: Not directly traceable (factory overhead)

By Decision Relevance

  • Opportunity cost: Value of next best alternative foregone
  • Sunk cost: Already incurred, irrelevant for future decisions
  • Incremental cost: Additional cost from a decision

Short-Run Cost Curves

Key Formulas

Total Cost (TC) = FC + VC

Average Fixed Cost (AFC) = FC / Q

Average Variable Cost (AVC) = VC / Q

Average Total Cost (ATC) = TC / Q = AFC + AVC

Marginal Cost (MC) = ΔTC / ΔQ

Cost Curve Shapes

  • AFC: Always declining (spreading fixed costs)
  • AVC: U-shaped (initially declining, then rising)
  • ATC: U-shaped (sum of AFC and AVC)
  • MC: U-shaped, intersects AVC and ATC at their minimum points

Important Cost Relationships

MC and ATC/AVC Relationship:
• When MC < ATC, ATC is falling
• When MC > ATC, ATC is rising
• MC = ATC at minimum ATC (efficient scale)
• Same relationship holds for MC and AVC

Why Costs First Fall, Then Rise

  • Falling phase: Specialization, spreading fixed costs, bulk discounts
  • Rising phase: Diminishing returns, coordination problems, overtime costs

Break-Even Analysis

Break-Even Quantity = FC / (P - AVC)

Break-Even Revenue = FC / Contribution Margin Ratio

Where Contribution Margin = P - AVC

Example

Fixed costs = ₹100,000, Price = ₹50, AVC = ₹30

Break-even = ₹100,000 / (₹50 - ₹30) = 5,000 units

At 5,000 units, total revenue = total cost = ₹250,000

Conclusion

Key Takeaways

  • Fixed costs don't change with output; variable costs do
  • TC = FC + VC; understand how each behaves
  • Marginal cost is key for production decisions
  • MC intersects ATC and AVC at their minimum points
  • Sunk costs should be ignored in decision-making
  • Opportunity cost is what you give up
  • Break-even shows minimum sales needed to cover costs