BE/U4 Topic 1 Concept of Cost, Cost function
Concept of Cost
In economics, cost can be defined as a monetary valuation of efforts, material, resources, time and utilities consumed, risks incurred, and opportunity forgone in the production of a good or service.
An organization incurs a number of costs, such as opportunity costs, fixed costs, implicit costs, explicit costs, social costs, and replacement costs. On the other hand, revenue is the income earned by an organization from the sales of goods or services. It excludes deductions of tax, interest, and dividend paid by an organization. The level of profitability of an organization can be determined by analyzing its costs and revenue.
Cost analysis involves the study of total costs incurred by an organization to acquire various resources, such as labor, raw materials, machines, land, and technology. It helps an organization to make various managerial decisions, including determination of price and level of current production.
Apart from this, it enables an organization to decide whether to opt for the available alternative or not. On the other hand, revenue analysis is a process of estimating the total income earned by an organization from different’ sources. An organization is said to be profitable if its total revenue is more than costs incurred by it.
Concept of Cost
Cost, a key concept in economics, is the monetary expense incurred ‘by organizations for various purposes, such as acquiring resources, producing goods and services, advertising, and hiring workers. In other words, cost can be defined as monetary expenses that are incurred by an organization for a specified tiling or activity.
According to Institute of Cost and Work Accountants (ICWA), cost implies “measurement in monetary terms of the amount of resources used for the purpose of production of goods or rendering services.” In terms of manufacturing, costs refer to sum total -of monetary value of resources used in producing or manufacturing a product. These resources can be raw material, labor, and land.
A cost function is a mathematical formula used to used to chart how production expenses will change at different output levels. In other words, it estimates the total cost of production given a specific quantity produced.
What Does Cost Function Mean?
Management uses this model to run different production scenarios and help predict what the total cost would be to produce a product at different levels of output. The cost function equation is expressed as C(x)= FC + V(x), where C equals total production cost, FC is total fixed costs, V is variable cost and x is the number of units.
Understanding a firm’s cost function is helpful in the budgeting process because it helps management understand the cost behavior of a product. This is vital to anticipate costs that will be incurred in the next operating period at the planned activity level. Also, this allows management to evaluate how efficiently the production process was at the end of the operating period.
The management of Duralex Companies, a manufacturer of toys, has asked for a new cost study to improve next year’s budget forecasts. They pay rent of $300 a month and they pay an average of $30 a month for electricity. Each toy requires $5 in plastic and $2 in cloth.
- How much will it cost them to manufacture 1200 toys annually?
- How much will it cost them to manufacture 1500 toys annually?
First thing to do is to determine which costs are fixed and which ones are variable. Remember, fixed costs are incurred whether or not we manufacture, whereas variable costs are incurred per unit of production. That means rent and electricity are fixed while plastic and cloth are variable costs.
Remember our cost function:
C(x) = FC + V(x)
Substitute the amounts.
- At 1200
C(1,200) = $3,960* + 1,200 ($5 + $2)
C(1,200) = $ 12,360
Therefore, it would take $11,360 to produce 1,200 toys in a year.
- At 1500
C(1,500) = $3,960* + 1,500 ($5 +$2)
Therefore, it would take $13,460 to produce 1,500 toys in a year.
*FC = (300 +30) * 12 months (remember we are asked at an annual basis).
Thus, FC= $ 3,960