Cost concepts: Fixed, Variable, Marginal, and Average Costs

Cost concepts are very important in business economics because they help firms in planning production, fixing prices, controlling expenses, and maximizing profit. Cost refers to the expenditure incurred by a firm on production of goods and services. In the short run and long run, different types of costs are studied to understand business behavior. The main cost concepts are Fixed Cost, Variable Cost, Marginal Cost, and Average Cost. Each cost has its own meaning, importance, and formula.

Fixed Cost:

Fixed cost is the cost that does not change with the level of output in the short run. It remains constant whether production is zero or maximum. Fixed costs are incurred even when no production takes place. Examples of fixed cost include rent of factory building, salaries of permanent staff, insurance charges, interest on capital, and depreciation of machinery.

In Indian industries, factory rent and manager salary are paid even if the factory is temporarily closed. Fixed cost is related to fixed factors of production like land and machinery. These costs can be changed only in the long run, not in the short run.

Fixed cost per unit decreases as output increases because the same cost is spread over more units. This is known as spreading effect of fixed cost. Fixed cost helps firms understand minimum expenses that must be recovered through sales.

Formula of Fixed Cost:

Total Fixed Cost TFC = Cost that remains constant at all output levels

Average Fixed Cost AFC = Total Fixed Cost divided by Quantity of Output

AFC = TFC ÷ Q

Variable Cost:

Variable cost is the cost that changes with change in the level of output. When output increases, variable cost increases, and when output decreases, variable cost decreases. Variable costs are related to variable factors of production such as labour, raw materials, power, fuel, and transport expenses.

In India, wages paid to daily wage workers, cost of raw materials, and electricity charges are examples of variable cost. If a firm produces nothing, variable cost becomes zero. Variable cost increases proportionately or sometimes at increasing rate depending on law of variable proportions.

Variable cost is very important for short run decision making. Firms compare variable cost with revenue to decide whether to continue production or shut down. If revenue covers variable cost, firms may continue production even if fixed cost is not fully recovered.

Formula of Variable Cost:

Total Variable Cost TVC = Cost that varies with output

Average Variable Cost AVC = Total Variable Cost divided by Quantity of Output

AVC = TVC ÷ Q

Marginal Cost:

Marginal cost is the additional cost incurred by producing one more unit of output. It shows the change in total cost due to a change in output by one unit. Marginal cost is very important for decision making related to output and pricing.

In business economics, marginal cost helps firms decide optimum level of production. Firms maximize profit where marginal cost equals marginal revenue. Marginal cost initially decreases due to better use of fixed factors and specialization of labour. After a certain level of output, marginal cost increases due to diminishing returns.

In Indian manufacturing units, when more labour is employed with fixed machinery, marginal cost falls initially but later rises due to overcrowding. Marginal cost is independent of fixed cost because fixed cost does not change with output.

Formula of Marginal Cost:

Marginal Cost MC = Change in Total Cost divided by Change in Quantity

MC = ΔTC ÷ ΔQ

Or

MC = TCₙ − TCₙ₋₁

Average Cost:

Average cost is the cost per unit of output. It is obtained by dividing total cost by total output. Average cost helps firms know how much it costs to produce one unit of a product. It is useful in pricing decisions and cost comparison.

Average cost is the sum of average fixed cost and average variable cost. Initially, average cost falls due to fall in average fixed cost and efficient use of resources. After reaching minimum point, average cost rises due to increase in average variable cost caused by diminishing returns.

In Indian industries, firms try to operate at minimum average cost to remain competitive. Average cost curve is U shaped due to combined effect of fixed and variable costs.

Formula of Average Cost:

Average Cost AC = Total Cost divided by Quantity

AC = TC ÷ Q

Or

AC = AFC + AVC