The Theory of Costs

All businesses should be able to fully understand their costs of production. Failure to do so is likely to lead to business failure, since there might be a possibility of operating at suboptimal levels.

In economics, by costs of production we refer to the prices paid for the factors of production and the opportunity cost attributable to factors already owned. It is important to note that we also factor in our costs formula the opportunity cost. In accounting, opportunity cost is often ignored.

Costs of production are divided into two categories: Fixed costs, these do not change with the level of production or activity; Variable costs, these costs vary with the level of activity or production.

It is important that we get ourselves familiar with some of the terms such as the the short run and the long run. The short run, in economics, is defined as a period of time in which at least one factor of production is fixed. On the contrary, in the long run, all factors are considered to be variable. However, it is assumed that the quality of the factors stays constant.

To understand the optimum level of output, we should operate at a point where the marginal cost of production equals the average production cost. The average cost is calculated by dividing the total costs by output, whereas the Marginal cost refers to the extra cost of increasing output by one unit.

The relationship of AC to MC in the short run is depicted in the following graph:

In the short run, the law of diminishing returns to a fixed factor ensures that the average cost curve (AC) is U shaped and the marginal cost curve (MC) cuts the AC curve from below at the lowest point of the AC curve. The level of output where average costs are minimised is the optimum output. If fixed costs and variable costs are added, they give the total cost of production at different levels of output.

The theory of diminishing marginal returns explains why, eventually, in the short-run average cost starts to rise. The production in the short run is characterised by diminishing returns and rising average costs, eventually. This gives rise to U-shaped cost curves.

U-shaped cost curves are shown in the following figure:

In the long run, because all factors of production are variable, an organisation can change its scale of production significantly. And, since there are no fixed factors in the long run, there are no long-run fixed costs.

The three possible shapes of the long-run average cost curve (LRAC) are shown in the following figure:

The long-run average cost curve for most businesses will be saucer-shaped.

The advantages of producing on a large scale are known as economies of scale. The economies of scale fall into two categories: Internal economies of scale whereby the organisation's average cost of production is reduced as the organisation itself becomes bigger. There exist four types of main internal economies: Technical economies; Financial economies; Trading economies; Managerial economies

External economies of scale whereby the organisation's average cost of production is reduced as the industry in which the organisation operates becomes bigger, even if the organisation itself does not.

Where the benefits of large scale production can accrue to all organisations in an expanding industry irrespective of the size and growth of the individual organisation, they are classed as external economies of scale.

It is also possible to have diseconomies of scale. These occur when the average cost of production rises with increased scale of production. Managerial diseconomies are probably the most important source of diseconomies of scale. Since the middle of the 20th century, most large organisations have responded to this problem by adopting a divisional structure.

Finally, note that in the short run, fixed costs are the same whether or not the organisation undertakes production. Variable costs are, however, avoidable if the organisation chooses not to start production. An organisation will undertake production in the short run provided the price it can obtain for its product is at least equal to the average variable cost of production.

The Goals of Organisations

The price, or exchange value, of a good or service usually indicates the resources which are brought together to produce or provide it.

Production is, usually, not adequate to meet all of needs. The fact that our needs are unlimited and yet resources are causes scarcity. Scarce resources, usually, command a high price. It is also worthwhile to note that, sometimes, there are competing ends for which resources could be used. If these ends are many and varied in importance and the means of achieving them are limited, then there is an economic problem and someone has to decide which end will be satisfied through production.

We sometimes talk about Relative scarcity of resources, which means that a choice has to be made. When a choice arises, an alternative has to be given up. The sacrifice, when a choice is made, is termed the opportunity cost because it is the next best alternative foregone. Usually, the opportunity cost has a monetary value.

In production, we need to make decisions in consideration of the fact that there is scarcity; the economic problem. The production decisions that need to be made when allocating scarce resources include the following: For whom to produce? What to produce? How to produce?How to distribute?

To tackle the economic problem, we obviously need resources. These resources are called the factors of production. These factors include the following: Land, whose reward is rent; Labour, which is rewarded through wages. Enterprise or entrepreneurship—The reward of risk-taking, organising and decision making earned by the entrepreneurs is termed profit and Capital, which is rewarded through interest.

The way in which scarce factors of production are employed and organised depends on the nature of the economic system which operates in a country. And, there are 3 possible economic systems, which are: Market economy; Mixed economy; Command economy

In practice we do not have a purely Market or Command economy, but rather a mix of the 2 systems. This is called the mixed economy. The main features of mixed economies are: Most economic activity is conducted by private sector, profit-seeking organisations; The price system plays an important role in resource allocation as it acts as a set of signals and incentives for both producers and consumers; Governments play an active role in the economy.

Also, note that the aims and activities of organisations are constrained, in practice, by certain factors such as the law, the nature of the business and human nature. And, in order to be able to calculate the profit maximising position for an organisation, it is first necessary to define certain concepts. These include: Total revenue (TR) = Volume of sales or Output x Sale price; Average revenue (AR) = Total revenue/Sales volume; Average revenue and sale price refer to the same thing; Marginal revenue (MR) = The change in total revenue when sales are increased by one unit; Total cost (TC) = The cost of all the resources employed in producing a given level of output including normal profit; Average cost (AC or ATC) = Total cost/Volume of output; Marginal cost (MC) = The change in total cost when output is increased by one unit.

Profit maximisation is where the difference between total revenue and total cost is greatest. This is always where marginal cost (MC) is equal to marginal revenue (MR). This is the equilibrium level of output for the organisation since it will wish to stay at this profit maximising level of output.

Please note that in Economics Total Cost includes an element for normal profit or opportunity cost.

Breakeven for an organisation occurs where average revenue equals average cost and total revenue equals total cost.

The amount of profit obtained and whether it is normal or abnormal depends upon: the market structure within which an organisation operates; the time period involved.

Although the not-for-profit organisations are not profit-orientated, as with most business organisations they have some characteristics in common with them. These include: Use of resources (factors of production) in order to produce some good or service; Flow of expenditure to finance those resources and other operating costs; Flow of income to finance the expenditure; Sales of services or goods to its customers, clients or members to obtain a flow of income

Overall, there are important economic constraints on organisations. These business organisations need to: avoid making a financial loss; be efficiently managed to ensure that the organisation achieves its objectives and ensures financial stability; choose investment projects carefully so that they contribute to the achievement of the objectives of the business in an efficient manner.

Finally, much of the management activity in not-for-profit organisations is similar to that which occurs in profit-seeking businesses. Similar decisions have to be made concerning the: types of product and service to be produced; markets to focus on; level of output to be produced; prices to be charged for the product or services; choice of production methods and technologies; investment decisions; sources of finance.